Citi: Sharp Rise in Yields to Subside

Municipal bond yields are likely to stabilize after surging the past few weeks, as new supply may decline in the second half of the year and individual investors may start to put their accumulated cash to work, according to strategists at Citi.

Since the end of April, yields on the Municipal Market Data's triple-A curve are up about 50 to 65 basis points from 10-year maturities out to 30-year maturities. On June 12, the 30-year triple-A yield was at 3.52%, up from 2.84% at the end of April.

"While the reasons for the rebound in muni yields have considerable power, we also believe strongly that the rebound will ultimately be self-limiting particularly over the short to intermediate term," muni strategists George Friedlander, Mikhail Foux, and Vikram Rai wrote in a report.

Heavy muni bond outflows, an anticipated rebound in new issue supply later in June, and concerns about a rotation out of fixed income and into equities are some causes of this "rapid erosion," according to the report, released Wednesday.

Other causes include concerns about a potential end to quantitative easing by the Federal Reserve, disappointing demand for additional munis as a large amount of existing bonds were called, and increased concerns about potential changes in the tax-exempt status.

One factor that will limit the rise in yields is the possible decline in supply during the second half. Citi said there is a potential for a decline in refunding volume, which could cause a gap this year in new issue supply. Citi had already revised its projection of $400 billion in new supply this year down to roughly last year's level of $377 billion. This modest supply could give the muni market time to "catch up."

In addition, individual investors, who have played a limited role in the muni market in recent quarters, could return in force at some point, as long as the yields being offered are perceived as providing a reasonable level of tax-free income.

Individual investors, who comprise the household sector, owned roughly $209 billion fewer municipal bonds at the end of March 2013 than at the end of the first quarter of 2010, according to the Federal Reserve Flow of Funds data.

While muni portfolios among households have been getting smaller, their assets in cash and near-cash form have substantially increased, the report noted, jumping from roughly $7.1 billion at the end of 2006 to roughly $10.2 billion at the end of the first quarter of 2013.

"We do not believe that muni yields will continue to go up sharply from here, but the road to muni market stability will not be smooth and easy," Citi said. "The period of muni fund outflows is most likely not yet over for several reasons, not least of which is the tendency of muni funds to see outflows while yields are moving higher."

The strategists said there is no doubt the momentum in the market is currently toward higher yields, although they are not in a hurry to jump into the long end right away. When yields move sharply in any sector, they said, there is real potential for an "overshoot" relative to the intrinsic worth of the bonds.

Citi strategists suggest that investors look for sectors, maturities, and structures in the market that have already become attractively priced, and ease back into the market over time.

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