After the biggest rally in U.S. local bonds in more than a decade, investors should prepare for the first year of losses since 2008, analysts at Morgan Stanley and Municipal Market Advisors predict.
The $3.7 trillion muni market has earned about 20 percent since the start of 2011, the best two-year run since 2001, Bank of America Merrill Lynch data show. The gains have been spurred by bets that taxes will rise and by the Federal Reserve’s move to increase holdings of longer-dated Treasuries.
While tax-exempt yields are the lowest since the 1960s, interest rates on Treasuries will probably rise next year, according to data compiled by Bloomberg. Yields on 10-year federal obligations will rise to 2.23 percent by the end of 2013, from about 1.59 percent yesterday, according to the median response of 70 analysts in a Bloomberg survey.
“The margin for error is so thin,” said Michael Zezas, Morgan Stanley’s head muni strategist, who correctly predicted in January that tax-free revenue debt would beat state and local general obligations this year. “With yields being at the historical lows they’re at, it only takes a small move higher in those yields before you realize negative returns.”
The muni rally has left investors with an insufficient cushion against rising Treasury interest rates, said Zezas. At current levels, a yield jump of as little as 0.18 percentage point in munis would outweigh interest income and produce losses for the next 12 months, said Zezas. His company is the fourth- biggest lead underwriter of muni deals this year, data compiled by Bloomberg show.
State and city debt has gained this year as defaults are set to be the lowest since at least 2009, contrary to a prediction two years ago by banking analyst Meredith Whitney that failures would escalate. The rally has accelerated since last month’s re-election of President Barack Obama, who wants to raise tax rates on top earners to help reduce the U.S. deficit.
Yields on 20-year general obligations fell last week to 3.29 percent, the lowest since September 1965, according to a Bond Buyer index. In January 2011 the interest rate reached 5.41 percent after Whitney’s default forecast.
Zezas expects a negative 1 percent total return in 2013. The muni market has gained for four straight years.