Despite projections that 2012 would see higher yields, municipal bond interest rates continued their descent, falling even further to hit record lows in November.
Municipal Market Data’s generic 10-year triple-A bond began the year at 1.88%, and the 30-year started at 3.57%. On Nov. 28, those yields dropped to lows of 1.47% and 2.47%, respectively.
The Bond Buyer 20-bond index also dropped in November to 3.29% — its lowest level since Sept. 2, 1965, when it was also 3.29%. The 20-bond index is based on a selection of general obligation bonds maturing in 20 years, with the average rating of the bonds roughly equivalent to a double-A.
Rates ended the year lower than they began at 1.72% in the 10-year, and 2.83% in the 30-year. The 20-bond index was at 3.58% as of Dec. 27, slightly down from the beginning of the year, when it was at 3.83%.
This year will be different. At least, that’s the common prediction among various municipal research analysts.
Bank of America Merrill Lynch expects some modest increase in muni rates next year of around 25 basis points to 1.93% on the 10-year triple-A bond,and 3.10% on the 30-year triple-A bond. That estimate is based on B of A’s average ratios to Treasuries, which are estimated to go up during the second half of 2013 to 2.0% in the 10-year and 3.25% in the 30-year.
“The big caveat is that it’s very supply sensitive,” said John Hallacy, head of municipal research for B of A Merrill. “It depends on how much muni supply we have across the curve, but especially in the long end, because any time we get hit with a fair amount of supply, the muni-to-Treasury ratio cheapens up a lot, driving rates and yields higher.”
Hallacy said other factors that will likely affect muni rates next year include impacts from the fiscal cliff resolution, as well as events in the global economy.
“We found that muni rates really rallied this year whenever the euro zone was having more difficulty,” he said. “That was a pretty strong relationship.”
Another factor is what Bank of America economists are calling a “great rotation” in which the inflows into fixed-income securities, including municial bonds, will reverse and shift towards equities.
Hallacy said they don’t expect the rotation to occur until later in the year, but it could eventually push muni rates higher.
JPMorgan is projecting a similar rise in interest rates, though not until the fourth quarter of 2013.
The firm expects 10-year and 30-year Treasury yields to be around 1.8% and 3.0%, respectively, over the first three quarters of next year, rising to 2.0% and 3.15% by year-end.
“We also anticipate generally low tax-exempt yields through [the third quarter],” according to a municipal outlook report written by Peter DeGroot, Lauren Tanenbaum and Karthik Narayan.
“By year-end, we look for higher tax-exempt yields, given rising Treasury market rates, with 5-year, 10-year and 30-year municipal rates rising by 24 basis points, 49 basis points and 57 basis points, respectively.” They expect the 10-year yield to start the year at 1.72% and end at 1.99%, and the 30-year yield to start at 2.88% and ending at 3.11%.
James Colby, portfolio manager and senior municipal strategist with Market Vectors ETFs, expects rates to trend higher, though they could remain in the same range depending on a variety of factors, including the fiscal cliff situation, the economic recovery, and supply.
Colby said that it’s hard to give a clear target in terms of rates, but suggested that we might see 30-year triple-A yields hovering around 3% to 3.25%, and in 10-year yields upwards of 2.5%.
“That’s purely conjecture and an awful lot of ingredients go into the stew to determine the outcome here,” he said. “So much of that is unknown or unknowable.”
The other big factor is whether the economy continues to recover. If the housing market improves or if unemployment continues to fall, that could put upward pressure on Treasury interest rates.
“So if we have an upturn in the economy and we get any amount of sell-off in Treasuries, resulting in higher interest rates, it would pull tax-exempt rates higher as well, which is a well-established pattern for our market,” Colby said.
The last factor he mentioned was an expected increase in supply next year due to issuers continuing to take advantage of low interest rates to achieve savings or budgetary needs.
“Any significant increase in supply might also be the catalyst for higher rates,” Colby said. “Often, I have observed that this scenario creates buying opportunities rather than long-term negative sentiment.”
Trident Municipal Research LLC is projecting that rates will remain stable with an upward bias for the first half of 2013, and then go higher in the second half of the year.
Last year, Trident had one of the more accurate predictions for 2012, estimating that the 10-year would decline to 1.50% by mid-year and remain there for the rest of the year, and the 30-year to decline to 2.75% by the end of the year. Rates haven’t quite ended that low, but they were right about the decline.
Bart Mosley, co-president of Trident, estimates that in the first quarter, 10-year Treasuries will move back up into the 2% range, and the 10-year triple-A municipal bond will be in the 1.95% range.
“By the end of the year, we think rates could be significantly higher,” Mosley said. “We’ll call it 3% on the Treasury, which puts us in a range of around 2.3% for the muni 10-year.”
Mosley said that the last couple of years have been relatively straightforward to form an interest rate and credit outlook for munis, but this year, it’s a much harder call.
“We basically have two sets of tensions driving things: the Fed’s ongoing accommodation versus the economy and actual inflation fears,” he said, adding that the tax exemption and budget talks are also factors. Those unknowns are as much psychology-driven as fundamental-driven, which makes it harder to have an outlook, Mosley said.
Loop Capital is also estimating an increase — albeit a smaller one— for this year. The firm projects the 30-year triple-A bond to start 2013 with a 2.60% yield, increasing by 10 bps each quarter to end the year at 2.90%.
The 10-year Treasury yield is estimated to be 1.65% in the first quarter and the 30-year to be 2.80%. By year-end, the yields are estimated to increase to 1.90% and 2.95%, respectively.
In a recent report, Loop Capital lists factors that would support higher rates, including the bond market’s long rally since March, consistent improvement in the housing market, high consumer confidence, perky auto sales and a rise in U.S. household wealth.
Factors that would support lower rates include the threat of sequestration which could cause a recession, the Federal Reserve’s commitment to buy long-term Treasuries each month, as well as mortgage-backed securities until unemployment rates fall, and Europe’s economic mess.
RBC Capital Markets is projecting a 10-year Treasury rate of between 1.6% and 2.2% next year, but the firm does not forecast muni rates, according to Chris Mauro, head of U.S. municipals strategy.