(Bloomberg) -- Outflows, weak supply, rising interest rates, and mediocre returns are forecast for the municipal market as it prepares to ring in 2014 in other words: more of the same.
Analysts and portfolio managers said they expect a continuation of the volatility that roiled the market in 2013, a tumultuous year that included the worst three-day sell-off in a quarter century and largest American municipal bankruptcy to date.
"2014 will have many of the same themes and challenges we witnessed in 2013, but the relative value of the municipal market will keep investors cautiously interested," said Roberto Roffo, senior vice president and portfolio manager with Advisors Asset Management.
"We expect another difficult year for municipal investors, with returns roughly flat to marginally positive," said Anthony Valeri, senior vice president of research at LPL Financial. "Fund outflows continue and are unlikely to reverse before year-end," he said earlier this month. "This creates a headwind for investors at the start of 2014, so the first few months may be challenging."
Peter Hayes, managing director and head of the municipal group at BlackRock Inc., said demand in January will be more subdued, with investors focusing on shorter duration securities. "Overall, the market will continue to see net negative supply and fund flows won't turn positive on a sustainable basis until Q2, meaning for the year, we are expecting only a modest positive number," Hayes said.
After 2013 gave long-term municipal mutual funds their worst year since 2008, they will be extra cautious in the coming year, analysts agreed.
Through Dec. 13, municipal bond funds posted negative returns of 3.658% on average, according to Morningstar Inc. Long-term open-ended muni funds posted negative returns of 4.28% through Nov. 18, which compares with gains of 10.07% in 2012.
Return prospects for the next 12 months are modest, but will improve as rates rise, Morgan Stanley analysts Michael Zezas and Meghan Robson wrote in a report. "As the economy transitions to a higher growth channel, we expect some more pain from rising rates before valuations become attractive."
David Litvack, managing director and head of tax-exempt research at U.S. Trust, Bank of America Private Wealth Management, agreed. "Concerns of Fed tapering and eventual increases in the Federal Funds rate will continue to dampen demand for munis, particularly on bonds with maturities longer than eight to 10 years," Litvack said.
The Federal Reserve Board started tapering its economic stimulus at the conclusion of the December meeting of the Federal Open Market Committee, reducing monthly bond purchases to $75 billion from $85 billion.
Last June, the market was rocked by a historic sell-off that catapulted rates nearly 60 basis points higher when, after positive economic news, Fed chairman Ben Bernanke first hinted at tapering. Yields climbed 55 basis points to 4.13% on June 24 and 25 from 3.58% in a three-day period beginning June 19 before rallying back to 3.83% on June 27. The generic, triple-A general obligation scale in 2043 stood at a 4.18% as of Dec. 20, according to Municipal Market Data.
Other turbulence in 2013 stemmed from apprehension over October's 16-day government shutdown, November's debt ceiling deadline, and the possibility that tax reform would include a reduction of municipals' tax-exemption. Municipal mutual funds have reported 30 consecutive weeks of outflows, according to Lipper FMI.
The tension was magnified when Detroit filed for bankruptcy in July, triggering fears over credit and a lengthy legal battle. On Dec. 3, a federal bankruptcy court judge ruled that the city is eligible for bankruptcy protection and can legally enter into Chapter 9.
"Munis are still a credit market with a rates problem, disposed to negative returns and volatile liquidity as the economy improves and rates rise," Morgan Stanley's Zezas and Robson wrote in their Dec. 3 research report detailing the firm's 2014 municipal outlook.
While analysts largely predict a modest increase in interest rates, some say the after-tax advantages and relative value of municipal bonds, as well as an improvement in credit deterioration, could help offset any immediate challenges.
"We expect investor sentiment and fund flows to improve as recession-driven credit weaknesses recede, although concerns about Fed tapering and higher interest rates will encourage duration limitations," said Alan Schankel, managing director of municipal bond strategy and research at Janney Montgomery Scott in Philadelphia.
Valeri, too, said 2014 won't be all bad: "Like 2013, we may see bouts of volatility that drives municipal prices down too far and creates buying opportunities," he said. "This happened during the middle of 2013 when municipals rose too far, too fast and cross-over buyers came in to support the market."
A repeat of that scenario, coupled with poor liquidity, could trigger price swings that "may once again be exaggerated, but create opportunities for buyers in 2014," Valeri said. "Tax-exempt yields approaching 5% on top quality names have brought out buyers in the past and will likely do so again should it happen in 2014."
Two of the biggest credit stories of the year Detroit's bankruptcy and cash-strapped Puerto Rico will continue to cast shadows on the municipal landscape in 2014, analysts and managers said.
"Puerto Rico will continue to cast a credit cloud," Schankel added.
The commonwealth's long-standing financial strain prevailed for most of 2013 as yields surged, and Gov. Alejandro Garcia Padilla worked to stem its budgetary shortfall by revenue generation and cost-cutting measures.
"Even though the number of defaults declined from 2012 to 2013, the scale of Detroit, and Puerto Rico potentially defaulting, added to the relative cheapness of the municipal market," Roffo said.
Moody's Investors Service on Dec. 12 put $52 billion of the island's debt on review for a possible downgrade to junk, citing declining net revenues, and high debt load and pension obligations that crimped its access to the capital market.
While Schankel said he doesn't see the commonwealth headed for default in the near future, "uncertainty about liquidity, market access, and the island economy will continue to generate investor caution," he said.
Strategists said the market will continue to learn from Detroit's bankruptcy in 2014. The city is trying to restructure $18.5 billion of debt over the course of its bankruptcy case.
"Bondholder treatment for holders of Detroit will be closely watched for precedents to inform how GO and other classes of debt should be considered on the credit spectrum," Schankel said.
Jefferson County, Ala. which also dominated headlines in 2013 concluded the nation's second-biggest municipal bankruptcy case in 2013 with the sale of $1.7 billion of new sewer warrants.
Those cases aside, experts believe there will be less overall credit deterioration in the year ahead.
"There may be additional bankruptcies in 2014, but we do not believe the trend will materially worsen," Litvack said. "We believe the improving economy is creating a more positive credit environment for most municipal issuers," Litvack forecast.
While he believes there will be a decline in the pace of credit downgrades, he said the recent bankruptcies and defaults will likely widen spreads for triple-B and lower rated bonds in 2014.
Analysts and portfolio managers structured their portfolios to plan ahead.
Valeri said his firm's forecast calls for high-quality municipal yields to rise by 0.3% to 0.8%, while Treasury yields 0.5% to 1.0%.
"We favor intermediate bonds as interest rate sensitivity will be a dominant theme in 2014," Valeri said. "I think intermediate bonds offer a good risk-reward. If interest rates fall by chance, intermediate bonds will still participate in an up market and provide portfolio diversification benefits as well as income benefits."
Hayes said if rates move higher, it may exacerbate investors' fears of further increases and keep outflows in place. "If market response is muted, the recognition of value should bring investors back," he said.
Others recognize the challenges, but are more optimistic about rates.
"We do not expect interest rates to rise sharply, since inflationary pressures remain low in the slow-growth economy," Schankel said.
"I believe that the economy is still not on solid footing and too many questions regarding the legitimacy of the current economic strength will keep a ceiling on how high rates can go," Roffo agreed.
Still, Roffo said retail investors should continue to be extremely cautious about rising rates and will continue to sell longer-date paper they favored for additional yield this year, but which is subject to increased volatility as rates rise.
"The forced liquidations by managers will cause municipals to stay relatively cheap or even get cheaper driving interest from cross-over buyers who realize that municipals offer an unparalleled value in the fixed income market," Roffo added.
On the political front, Valeri said a divided Congress means tax reform is unlikely in 2014.
In terms of volume, long-term new-money supply is expected to largely track that of 2013, as issuers continue with moderate capital programs in response to slow economic growth, Schankel pointed out.
Most recently, municipalities brought 771 long-term issues totaling $23.2 billion to market during November 2013, which trailed by 31.3% the pace of November 2012, when issuers sold 1,163 issues totaling $33.8 billion, according to Thomson Reuters.
"We expect the total of municipal bonds outstanding to continue recent modest declines based on Fed data as new-money issuance does not quite keep pace with maturities," Schankel said.
Likewise, Valeri said he expects net supply in 2014 to be roughly zero, which will provide "a favorable longer-term supply-demand balance that may help the broader municipal market later in the year."
The Morgan Stanley report calls for a 10% reduction in gross supply to $285 billion, driven largely by declines in refundings. "Net supply should increase to $42 billion, which is still historically low," the analysts stated.
Tax advantages, meanwhile, could boost demand for municipals in general, Schankel noted.
"When April 15 rolls around, and upper bracket investors assess the impact of a higher federal bracket at 39.6%, the new Medicare Investment Tax of 3.8%, and in some cases, higher state income tax rates," he said, "the increased after-tax benefit of tax-free municipal bonds will become increasingly apparent, driving increased demand."