The stars aligned for the municipal bond market in 2014: Low supply amid solid demand, improving fiscal conditions among state and local issuers, and a broad drop in interest rates (and rise in bond prices) helped make munis one of the top-performing fixed income asset classes of the year. Many of the favorable dynamics remain firmly intact heading into 2015. But even though the sun doesn’t set on munis in 2015, 2014 was in many ways a gift that can’t keep giving indefinitely. What may be in store for 2015?:

A return to “normal.” The Fed is poised to set on a course to normalize interest rates in 2015 after six years of excessively easy policy. And muni returns are likely to ease from their 2014 euphoria and approach more typical levels.

Continued strength, technically speaking. While muni supply may pick up versus 2014, demand for high-quality income-producing assets is voracious in the current environment. That makes for a good technical backdrop that should support muni pricing.

Pension pain and hope for remedies. Pension liabilities present the biggest long-term fiscal challenge for many state and local governments. Issuers’ ability to implement reform will be a key differentiator in the market.

What can investors expect from munis after the stellar total returns achieved in 2014?

2014 represented a sharp reversal from the prior year. Everything that didn’t work in 2013 worked in 2014: Long-duration and higher-yielding credits led the market as investors stretched for yield. Rates fell and prices rose, lending additional support. And 2013 outflows reverted to solid inflows. All told, the stars aligned in spectacular fashion.

2015 may feel ho-hum in comparison, but certainly not a bad year from a historical perspective. Many of the tailwinds that helped the market in 2014 remain in place. But we also have headwinds, the most notable being a Fed that is ready to begin raising interest rates. At minimum, that will create volatility in the market.

A look at long-term patterns also is informative. (See chart on next page.) 2014 was a bounce-back year for the municipal market. The S&P Municipal Bond Index returned 9.26%. Historically, returns in the year following a bounce back have been two-thirds lower than the bounce. That would equate to a return of roughly 3%-3.5% in 2015.

In many ways, 2014 was a gift—and it can’t keep giving forever. Investors need to remember that munis are designed to be high-quality income vehicles, not drivers of total return.



Do you expect the favorable supply/demand scenario to persist in 2015?

We expect issuance to pick up somewhat in 2015. Our base case is for muni supply to increase roughly 5% over 2014, with the greater risk to this view being to the upside given the current shape of the yield curve and the still low-rate environment. One reason for that is the fact that the pool
of refundable/callable bonds will be higher than it was in 2014 (there were more bonds issued in 2005 that will be meeting their 10-year call date).

That means more bonds being refinanced and reissued back into the market. In addition, borrowing conditions are favorable (i.e., rates are low) and issuers have better balance sheets than they’ve had in five or six years. That equates to greater ability and willingness to borrow. In fact, the aversion to debt finally appears to be breaking a bit. We saw evidence of this on Election Day when, nationwide, 84% of bond ballot initiatives won voter approval. This gives legislators political leeway to begin issuing debt again. It also demonstrates a move away from the most austere times that states and locals had existed in for some time.

All of that said, we are still anticipating a net negative supply scenario in 2015, albeit to a lesser degree than in recent years. In other words, demand should continue  to outstrip supply, as munis remain attractively valued versus their taxable counterparts (especially intermediate and long maturities) and continue to draw the attention of crossover buyers (i.e., taxable fixed income investors). That should translate into positive fund flows which, in turn, should lend stability to the market.
 
So technicals still look good. How are fundamentals in the municipal market?

We would say the underlying creditworthiness of municipal issuers is the strongest it has been since 2008. State balance sheets are in good shape, budgets have largely been balanced and passed on time, and some states have even been able to bolster rainy day funds. Defaults are on pace to be at their lowest in three years. In 2014, roughly $1.15 billion in outstanding municipal debt entered into default (that’s just 0.031% of total munis outstanding). These numbers were more than double in 2013, at $2.6 billion in defaulted debt (representing 0.076% of munis outstanding).
What is the biggest challenge facing municipalities now?

Far and away, it’s pensions. Pensions will be the big differentiator going forward. Up to this point, state and  local governments have had to focus on the short-term: balancing budgets year by year. Now that their short-term fiscal house is in order, attention turns to their longer-term obligations, the biggest and most onerous of which are pensions. In fiscal year 2012 (the latest data available), states’ unfunded pension benefits totaled $915 billion, and other retirement costs (specifically, other post-employment benefits or OPEB liabilities) stood at $577 billion. The latter includes health care and other non-pension benefits.

So far, states and locals haven’t been severely punished  for not addressing their pension issues. There have been some ratings downgrades based on pension concerns, but market pricing is just now starting to differentiate between governments that are addressing the issues and those that are not.



The big one to watch is Illinois, which has the largest pension funding shortfall in the nation at $111 billion. Reform measures have been contested there and are now being addressed by the Illinois State Supreme Court. We could see an outcome in 2015 that has important implications for pension reform efforts more broadly going forward. In fact, I wouldn’t be surprised to see the issue of contract impairment by states and cities eventually go to the U.S. Supreme Court. New Jersey is another one to watch and, to a lesser degree, Pennsylvania and Connecticut.

Pension reform is an important topic. In addition to helping improve balance sheets, reducing these long-term liabilities could free up funding for much needed infrastructure spending.

High yield beat the broader muni market in 2014. What do you expect in that space in 2015?

We think high yield munis should do better than the broader market again, if only because you have the benefit of carry (i.e., higher interest earnings). That said, the sector is already expensive given its recent run, so we wouldn’t expect a great deal of price appreciation.

Puerto Rico is the major name in the high yield category. Is 2015 a year of reckoning or will we see improving conditions for the island?

Puerto Rico’s story continues to be written, but we don’t see the ending changing much at all. It’s an overleveraged economy that continues to struggle to remain solvent. We still see restructuring as the outcome. It could be 12-18 months away as the island continues to buy time via borrowing to meet its expenses, but the problems are just too large to tackle with short-term band-aids. We continue to limit our exposure to Puerto Rico debt.
 
While absolute yields appear low after the phenomenal run of 2014, munis still represent good value versus the taxable alternatives. At Dec. 31, we had a 30-year muni yield of 2.84% (which equates to a 5.02% taxable equivalent yield*) vs. 2.75% on a 30-year Treasury. So a higher yield to begin with, and then you factor in the tax exemption and munis look that much better. It’s little surprise municipal bonds are attracting the attention of crossover buyers.

Munis are a high-quality, relatively low-volatility source of income with a taxable equivalent yield that is quite appealing, particularly for longer maturities.

We believe the asset class deserves a place in an investor’s portfolio, especially those in high tax brackets seeking to keep more of what they earn. In addition to the attractive relative income they offer today, munis represent an important source of diversification in a well-rounded fixed income portfolio. So not only are munis worth buying now, they are also worth holding long term as a core component of your portfolio.
What should investors focus on in positioning their muni allocations for 2015?

We think yield curve positioning will be very important in 2015, particularly as the Fed prepares to raise interest rates. I’ll preface this by saying our view on the Fed and interest rates is perhaps more benign than some prognosticators. The central bank maintained its “considerable time” language in December, which the market reads as six months. That would imply a rate hike no sooner than June—perhaps later. Overall, we expect the Fed to move later than some forecasts project, although continued strong U.S. employment data could force the central bankers to move a bit sooner.



What does that mean for the yield curve? We expect the curve to flatten, with greater value at the long end as the front end bears the brunt of the Fed rate hikes. This is different from other tightening cycles. Why? There are a few reasons, but one is the lack of inflation in the economy. Low inflation should equate to low-for-longer long-term rates. There’s also the fact that interest rates on foreign bonds are so low that U.S. rates are attractive in comparison. This is stoking demand for long- term U.S. bonds, propping up their prices and keeping yields low. Bottom line: We continue to prefer longer maturities for incremental yield and lower volatility.

The chart above illustrates the change in the yield curve from 2006 to today. The front end has been very low under the Fed’s zero interest rate policy. We would expect rate hikes to impact this end of the curve and produce a flatter curve closer to what we had in 2006 (emphasis on the shape/slope, not on the actual yields).

Any other advice for investors as we kick off a new year?

We’d urge investors to approach the market with proper perspective. Munis are not designed to generate total return, although that was a tremendous benefit in 2014. Investors who are expecting more of the same in 2015 may be disappointed. Investors should focus on income and the tax benefit that is unique to the municipal asset class.

Investors should also get comfortable with the fact that rates are not going up dramatically. We’re very likely in a “low for longer” world. Against this backdrop, some allocation to high yield probably makes sense in 2015, but balanced with high quality. High-quality investment-grade bonds are useful for liquidity and trading flexibility, while less-liquid high yield bonds offer the potential for income enhancement.

We would also caution investors to avoid the extremes:
Don’t take on more risk than you can stomach, either by extending too far out on the curve and/or by taking excessive credit risk. At the same time, don’t get too defensive. Exiting the market and holding cash is not advisable.

And importantly, know what you own. Credit research is an absolute necessity and is at the core of our process here at BlackRock. In addition to referencing the agencies’ ratings, we assign an internal rating to every credit and issuer before considering it for inclusion in our portfolios. We’re cognizant that avoiding the wrong credits is as important as owning the right ones.

Peter Hayes, is head of the Municipal Bonds Group at BlackRock and a member of the Americas Fixed Income Executive Team. He leads the Municipal Bond Operating Committee, which oversees municipal bond portfolio management, research and trading activities, and is a member of the firm’s Global Operating Committee. Mr. Hayes’ service with BlackRock dates back to 1987, including his years with Merrill Lynch Investment Managers (MLIM).