Munis Surprise with Strong 2014
The strength of the municipal market in 2014 caught many analysts off guard as the unexpected and historic decline in long-term yields heightened demand and made for an attractive year that was highlighted by 9% returns.
"The big surprise was that rates actually fell, and 99.9% of analysts and strategists thought rates would go higher," said Peter Hayes, managing director of the municipal group at BlackRock Inc. in a Dec. 8 interview.
Municipals delivered solid performance overall thanks to the strength of the long duration and high-yield segments of the $3.63 trillion municipal market.
Yields on the 30-year benchmark triple -A general obligation bond have fallen more than 100 basis points to 2.87% as of Dec. 18, down from 4.20% on Jan. 2, according to Municipal Market Data. Yields on high-quality bonds on MMD's benchmark scale maturing in 20 years and beyond fell the most since 2004.
The falling rates boosted the performance of longer duration bonds, analysts said.
Municipals delivered positive returns for the 11th straight month, returning 0.77% in November, Justin Hoogendoorn, CFA and managing director at BMO Capital Markets wrote in a monthly bond market outlook report dated Dec. 15.
Total returns stand at 9.14% this year, which is boosted to a tax-adjusted 11.67%, he said.
"That strength was more than most expected," said Anthony Valeri, a market strategist at LPL Financial in a Dec. 3 interview. He said most people expected rates to be flat to marginally positive.
He pointed to the drop in long-term yields as the biggest driver of the strong performance, followed by declining supply and cheaper valuations early in the year.
A combination of factors fostered the long-term decline in rates in 2014, including a weak first quarter, negative gross domestic product, and decelerating and questionable economic growth overseas in Europe and China, according to Valeri.
"We thought munis were going to be one of the best performing because of the low supply and tax advantages, but we were surprised by the way the yield curve fluctuated down instead of up -- and the way investors were less concerned about the overall credit conditions than we thought," said David Litvack, head of tax-exempt fixed income research at U.S. Trust, in an interview on Dec. 4.
"Like many, we expected interest rates to rise moderately and they didn't, but we believed munis would be the strongest income play, which has worked out," said Alan Schankel, managing director at Janney Montgomery Scott, in an email on Dec. 4.
Besides the low supply, Litvack said robust demand helped performance.
"Demand was driven by basically declining Treasury yields which impacted all fixed-income sectors," he said. "In the case of munis it was helped by generally improving credit and new-found appreciation for tax advantages of munis," Litvack added.
"We were surprised it took so long for tax payers to appreciate that munis were attractive," he said. "A lot of investors didn't understand that until 2014, and that led to big inflows into muni bond mutual funds."
Municipal bond mutual funds generated $23 billion of total net assets through Dec. 18 in 2014, following a record $64.2 billion of outflows in the previous year, according to Lipper Inc.
Demand was fairly consistent as these investors favored municipals' "compelling" risk-reward, duration, and high-quality offered by the asset class, Hayes said.
"The raise in federal taxes was not absorbed by the market and we called for large total rates of return," said Phil Fischer, head of municipal bond research at Bank of America Merrill Lynch in an interview on Dec. 10. "The first quarter of economic activity was extremely low, and through time the municipal market started to normalize," Fischer explained.
"Issuance was lower than most people expected and slowed the market, but the increasing issuance hasn't really punished and impacted the market like in recent years," Valeri said.
However, he said demand was more than sufficient. "Light issuance for much of the year created lingering pent-up demand that seemed to absorb it better than prior years," he said.
Thomson Reuters reported $312 billion of issuance as of Dec. 17, but some analysts believe the total will be much higher. Fischer believes volume will end up around $350 billion - up from his initial $330 billion prediction at the start of the year.
Patrick Early, chief municipal analyst at Wells Fargo Advisors, said a 4% year over year decline in supply was the catalyst for the strong performance.
"Supply picked up in the second half of the year and is finishing on an uptick," he said in a Dec. 8 interview.
December is usually marked by high issuance as municipalities rush to market to sell debt before year-end - and that is especially true this year as they aimed to take advantage of lower interest rates, said Dorian Jamison, municipal analyst at Wells Fargo Advisors, in the same interview.
The 30-day visible supply was at a two-year high in the week of Dec. 15 at $19.1 billion, and analysts said the excess supply helped cheapen the market.
Hayes predicted that the year should end between $310 billion and $320 billion - on target with his initial forecast of $310 billion coming into 2014.
Early and Jamison noted that strong demand in 2014 supported 30 weeks of inflows into municipal bond funds.
"That was really the opposite of what we saw in 2013 with more than 30 week of consecutive outflows," Jamison said. "The strong demand was taking advantage of opportunities that arose after the sell-off we ended 2013 with, as well as a decline in supply - that helped the market out quite a bit."
Heavy demand helped mitigate the lower rates and a decline in the municipal to Treasury ratios from its two-year high of 110% in June 2013, Early and Jamison said.
The ratio was inching back to that historic level as it hit 104.8% on Dec. 18, after rising from 92% on Dec. 8, and 83% back in April 2014.
Though households pared their holdings by $47.6 billion in the third quarter, the largest holders of municipal debt still owned more than $1.6 trillion at the end of the third quarter, according to the Federal Reserve. "Demand remained strong even though the relative value has been less attractive going back to 2013," Early said.
"Inflows were robust and continue to be relatively steady" despite some periods of decline, Valeri agreed.
Karissa McDonough, director of fixed income strategy for People's United Bank Wealth Management, an investment management firm with $5.5 billion in assets, said while the curve has flattened substantially this year, it does remain steep from a historical perspective.
Still, 2014 had its challenges.
Besides the waning supply most of the year, one of the other biggest obstacles in 2014 was the market's preoccupation with the timing of a potential rate hike by the Federal Reserve Board, analysts said.
"We did see yields spike back when there was talk about rates going up - and that was an underlying concern throughout the year," Jamison said on Dec. 8. However, those fears were offset by the lack of supply earlier in the year, which supported strong demand, he added.
Fed chairman Janet Yellen on Dec. 17 told reporters after a two-day Federal Open Market Committee meeting that the Fed is likely to hold rates near zero at least through the first quarter, with a hike not possible until certain economic parameters are met later in 2015.
Treasuries reacted to the Fed announcement by soaring nine basis points on Dec. 18 as prices sank the most in 17 months on speculation borrowing costs will rise next year, equities rallied, and oil resumed its selloff, according to Bloomberg.
The benchmark lending rate has been in a range of zero to 0.25% since December 2008. The yield on 10-year Treasuries rose eight basis points to 2.14% following the Fed announcement, while the 10-year municipal yield ended up three basis points at a 1.99%, according to Municipal Market Data.
One of the biggest defeats was the September ruling by the Federal Reserve that excluded municipal bonds from the list of high-quality liquid assets that can be held by large and internationally-active banking institutions.
The rule, which goes into effect Jan. 1, excludes state and municipal bonds from the various categories of HQLAs that make up the bank's liquidity coverage ratio during a 30-day stress period.
However, in its ruling the Fed considered possible review and inclusion at a later date if their liquidity is comparable to the highly liquid corporate bonds that do qualify.
Among other major developments this year, the Fed officially ended its quantitative easing program in October with a final $15 billion purchase. It began tapering its economic stimulus program by $10 billion a month starting back in December 2013.
Growing credit improvement in 2014 was a score for the municipal market specifically.
"Municipalities continued their long and rocky path towards a healthier backdrop in 2014, as default activity declined and pension funding rose," Hoogendoorn said in his report.
In addition, the approval of Detroit's bankruptcy filing was a major development for the municipal market - on the heels of much financial, legal, political, and credit turmoil leading up to the court ruling.
The city of Stockton, Calif., in October also received federal approval to exit Chapter 9 bankruptcy.
"Looking back, Detroit, and to a lesser extent Stockton, [Calif.] weighed on the market," Schankel said. "Confirmation recently of the two bankruptcy plans leaves questions about pensions versus bond-holders but enables the market to move on."
Overall, a decline in negative credit headlines helped boost performance in 2014, according to Hayes.
"The initial shock and awe of those headlines occurred in 2013, and by the time 2014 rolled around, mid-year a lot of those had been evolving situations," Hayes explained. "Investors got comfortable with the risk or sold the risk to another buyer," he said.
Fischer agreed. "We have gotten the market to the point where PR is well enough understood where it is not a systemic risk to the market."
Puerto Rico's legislature in early December passed a $2.9 billion borrowing measure that would repay money owed to the Government Development Bank and fund public transportation.
Litvack of U.S. Bank, however, said investors had an unexpected reaction to the credit concerns of Detroit and Puerto Rico.
"I was surprised that investors were not spooked by the problems in Puerto Rico and Detroit, and it turns out high-yield outperformed investment-grade bonds," Litvack said.
"Investors were able to compartmentalize the problems with those bankrupt cities and the generally improving economy favored the larger swath of muni issuers," Litvack added.
"Pension funding was and will continue to be the bigger picture cloud overhanging state and local government fiscal health," Schankel said.