Investors seeking higher returns are finding them in an unexpected place: the market for debt sold by states, cities and government-related entities.
Municipal bonds have posted their longest string of monthly gains in more than two decades, outpacing gains this year in blue-chip U.S. stocks and corporate debt. The rally is pushing down borrowing costs for scores of municipalities, enabling even cash-strapped ones to tap capital markets.
The gains stand out following the $3.7 trillion sector’s 2.55% decline in returns last year, driven by Detroit’s record bankruptcy and Puerto Rico’s financial woes. That pullback revived calls by market pundits since the financial crisis that municipal debt was vulnerable to an investor exodus.
Municipal bonds have returned 8.32% in 2014 through Friday, including price gains and interest payments, according to BarclaysPLC. That compares with 6.86% for the Dow Jones Industrial Average, 6.68% for highly rated corporate debt and 4.07% for U.S. Treasury debt.
Many municipal bonds are considered nearly as safe as Treasurys because they are backed by tax revenue. Some of the biggest beneficiaries of the rally have been issuers of lower-rated debt, such as a $3.5 billion sale by Puerto Rico, $241 million of bonds backed by hotel and alcoholic-beverage revenue in Atlantic City, N.J., and a $1.4 billion offering from a struggling Southern California toll road.
Amy Potter, chief financial officer for the Transportation Corridor Agencies, which oversee the 15-mile toll road in Orange County, Calif., said investor demand allowed the authority to increase its borrowing, refinancing more of its debt and lowering its interest payments.
“We were able to exceed all of those goals, so we’re extremely pleased,” she said.
At the same time, low overall borrowing by cities and states has reduced the supply of bonds, while higher tax rates have increased the relative attractiveness of tax-exempt municipal debt to investors looking for a haven, said Paul Palmeri, head of the public-finance group at J.P. Morgan Chase & Co.
“You have the perfect mix this year,” he said.
The broad debt-market rally that has upended Wall Street bets on rising interest rates has fueled a surge of investor funds into municipal debt. Yields on debt issued by states, cities and local government-related entities fell to 1.94% in mid-October, their lowest in two years, according to Barclays data. Yields fall when prices rise.
Investors, led by retail investors purchasing the debt through mutual funds, have poured $18.2 billion into municipal-bond funds so far this year, according to Lipper. They withdrew $48.38 billion in the same period last year.
The warming trend is likely to continue, analysts and traders say. The supply of new muni bonds declined 10.5% to $227.8 billion in the first nine months of the year from the same period last year, according to data from the Securities Industry and Financial Markets Association trade group, following a decline in 2013.
That leaves investors lining up for the few new bonds that come to market, said Daniel Solender, director of municipal-bond management at Lord Abbett & Co., which oversees about $16 billion in tax-exempt bonds.
For a New York investor in the highest tax bracket, a top-rated state bond maturing in 10 years and yielding about 2% would be the equivalent of a taxable bond yielding about 3.9%, he said.
“Every deal that’s priced appropriately gets plenty of interest,” said Mr. Solender. “Since it’s been slow so long, there’s pent up demand waiting.”
The gains have helped municipal-bond investors overcome fears about unfunded pensions or other looming fiscal problems in specific cities or states, said Thomas McLoughlin, co-head of fundamental research at UBS Wealth Management Americas.
Rabbi David Teutsch, a professor at the Reconstructionist Rabbinical College near Philadelphia, said he invests in municipal bonds for capital preservation and he doesn’t think too much about the market’s ups and downs. “It’s not like because they’re worth more, I’m going to sell them,” he said. “In the long run, the fluctuations don’t matter that much to me.”
The election calendar doesn’t promise heavy bond issuance. The ballot includes about $44.7 billion in possible bond issues, according to Ipreo. Voters must approve municipal-bond issuance in many U.S. jurisdictions.
Demand also has been robust amid the return of large price swings in stocks and bonds. Purchases of municipal bonds spiked when the Dow and U.S. Treasury yields fell sharply on Oct. 15, according to the Municipal Securities Rulemaking Board.
Even the threat posed by Puerto Rico, which is trying to recover after its debt was downgraded to junk in February, hasn’t scared off many investors. The U.S. commonwealth has about $73 billion in debt, which is widely held by individuals, mutual funds and hedge funds. In June, the island’s public officials passed legislation allowing some public agencies to restructure billions.
Many investors have sold their Puerto Rico holdings to hedge funds or other distressed-debt funds that are savvy about the risk, said James Iselin, head of municipal fixed income at Neuberger Berman, which manages about $10 billion in tax-exempt debt. Puerto Rico bonds have returned 11.96% this year, according to Barclays.
Others are steering clear, saying that investors should focus on higher-quality debt bearing more-modest interest rates.
“We don’t buy yield for yield’s sake,” said Stephen Czepiel, senior portfolio manager at Delaware Investments, which supervises about $132 billion in U.S. fixed-income assets. “Even in a limited-supply atmosphere, don’t deviate from the credit fundamentals.”
By Aaron KuriloffReturns on Muni Bonds Soar
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