The second half of 2014 promises more positive returns for municipal bonds even as investors react to declining credit quality in Puerto Rico, according to midyear analyst reports.
Based on the trends in the first six months, demand is forecast to be strong to steady while new supply is expected to lag behind redemptions, providing support for muni prices. Experts are predicting modest interest-rate increases, based on statements from the Federal Reserve, and see volume of roughly $300 billion for the calendar year.
"June was a fairly active month in terms of municipal bond issuance and headlines, yet the market ended close to unchanged," wrote Peter Hayes, head of the municipal bonds group at BlackRock Inc., with fellow authors James Schwartz, head of municipal credit research and municipal strategist Sean Carney, in a monthly municipal update on July 7.
"Municipals essentially ended [June] flat, but hit the mid-year point emphatically in the black," the BlackRock analysts wrote, noting that the S&P Municipal Bond Index posted a year-to-date return of 6.08%.
"Demand held firm while the net-negative supply scenario remained intact, underpinning muni pricing," they added. Net negative supply occurs when redemptions outpace new issuance.
Issuance for June was $34 billion, which BlackRock said is consistent with the five-year average for the month and was up 32% from the prior month.
Municipal performance was buoyed by weak U.S. economic data - first quarter gross domestic product growth was revised downward to negative 2.9% ¬ and "a still-accommodative Fed," the BlackRock analysts wrote.
The team said municipals are on pace for $300 billion in total issuance for 2014, in line with the firm's earlier forecast of $305 billion. That volume implies a net-negative supply of $40 billion.
Other positives in the first half included triple-A-rated municipals outperforming U.S. Treasuries across the yield curve, with the ratio ending the second quarter at 98%, down from 102% at the start of the quarter, analysts from Prudential's fixed income team noted in a third quarter outlook published on July 8.
Brian Rehling, chief fixed income strategist at Wells Fargo Advisors, pointed to the Bank of America-Merrill Lynch Municipal Master Index, which returned 5.90% at the close of the first quarter, as evidence of the market's strength in his July 8 weekly fixed income report.
He said the longer duration inherent in the municipal market and a favorable supply calendar led to the tax-exempt market posting strong returns in the first half of the year, despite some isolated credit events.
Puerto Rico and Detroit were the most attention-grabbing stories of the first half, yet the market took them in stride, muni analysts said.
"It was notable that municipal investors were able to look past both the downgrade of Puerto Rico, which took the high-profile credit below investment grade, and the bankruptcy in Detroit," Rehling said in his report.
More recent developments in the U.S. territory, including a new law allowing public corporations to restructure their debt, have the potential to undercut muni demand.
"Multiple downgrades for various Puerto Rico credits and the significant sell-off could lead to mutual fund outflows following a six-month period of moderately positive flows into municipal funds," the Prudential analysts wrote.
"While a range-bound interest rate environment should be supportive of modestly positive fund flows," they added, "the negative returns and headlines associated with Puerto Rico could upset this picture."
Roosevelt D. Bowman, senior fixed income analyst at U.S. Bank Wealth Management said in a weekly market update on Wednesday that investor sentiment towards Puerto Rico "continued to sour as government officials proposed a restructuring of some debt issues.
"We remain very wary of Puerto Rican fixed income as a faltering economy, the associated sluggish tax revenue, and budget challenges all continue to weigh on the commonwealth," Bowman wrote.
The forecast ahead, however, is mostly favorable for munis, the analysts said.
Rehling expects overall muni credit to continue to outperform as it did in the first half and suggests investors own bonds for stability, avoid reaching for yield, and maintain portfolio diversification.
"During 2014's second half, we expect interest rates to move modestly higher from current levels, but anticipate that any increases will be well-contained," Rehling wrote.
"A controlled rising rate environment should allow fixed income investors to generate positive returns, albeit lower than experienced in past year," Rehling said, suggesting an average annual total return of between 2% and 4% for well-diversified, domestic, investment-grade, fixed-income investors.
Anthony Valeri, investment strategist at LPL Financial suggests staying defensive to curtail the impact on municipals from rising interest rates going forward.
"Among high-quality bonds, shorter-term bonds with less sensitivity to rising interest rates may help buffer fixed income portfolios from price declines associated with rising interest rates," Valeri wrote in his July 3 fixed-income mid-year outlook.
At Prudential, the fixed income team believes the municipal market continues to provide attractive taxable-equivalent yields for individuals in the top tax bracket, and regard near-term technical factors, such as net supply, as "extremely supportive."
Prudential analysts cited research from JPMorgan that estimates net supply of negative $21 billion for July and August, and net supply of negative $35.4 billion in 2014, with a full year gross issuance estimated at $300 to $310 billion.
BlackRock believes performance in the second half is likely to be derived from security selection and the ability to rotate between sectors and adjust duration as conditions warrant.
"We expect this will be particularly important as summer apathy sets in and as events in Puerto Rico evolve, potentially presenting opportunities to capture value in the market," the BlackRock analysts wrote.
In the meantime, the team is recommending a barbell approach to both credit and the yield curve, favoring maturities below two years for trading flexibility and above 15 years.
"While short-term and intermediate munis are looking expensive, longer maturities continue to appear attractive versus Treasuries and, we believe, represent the best absolute and relative value."
