BlackRock Inc. says municipal bonds will extend April's gains as the second quarter progresses, though credit quality concerns remain for investors in Puerto Rico, New Jersey and tobacco bonds.
"Municipal bonds posted positive returns and outperformed Treasuries for the month, achieving their largest April gains since 2011," Peter Hayes, managing director and head of the municipal group, wrote in a monthly report last week. "Long-duration and lower-rated revenue bonds fared particularly well."
The S&P Municipal Bond Index returned 1.20% in April and 4.78% year-to-date, Hayes noted.
"Returns were positive across the curve, led by the long end. High yield, despite under-performing modestly for the month, is well ahead" year to date, he wrote.
Hayes attributed the market's solid performance to two key factors: interest rates that remained in a narrow range as tensions over Ukraine supported price appreciation for high-quality income assets, and the market's strong technical and fundamental trends.
Strong flows into municipal mutual funds resulted in little selling pressure ahead of the April 15 tax deadline, when investors typically sell municipals to pay tax bills, and are proof that demand remains firm into May, Hayes added.
"The prevailing imbalance in supply and demand, coupled with a supportive macro backdrop, continues to propel the market," he wrote.
New-issue supply continues to "underwhelm" expectations as April's issuance came in roughly 20% below the five and 10-year averages, Hayes noted, probably reflecting "ongoing post-crisis fiscal prudence and a general aversion to taking on new debt."
Hayes said being cautious on credit will aid performance going forward.
For instance, he is monitoring the recovery of Puerto Rico, as well as the developments of other island municipalities and sectors.
"The Commonwealth's fiscal year 2015 budget is being billed by the administration as 'balanced,' however, important details are still to be worked out and the proposal, while commendable, may be difficult to achieve," Hayes wrote.
He also is also wary of the island's plans to use capitalized interest from its most recent borrowing to pay debt service on the bonds, which he said is "an uncommon practice for a general obligation issue."
New Jersey's reduced reserves, high overall leverage, and large unfunded pension liabilities may pose continued challenges, Hayes said, in light of its recent downgrade from both Standard & Poor's and Fitch Ratings to A-plus from AA-minus due to limited flexibility in curing large budget gaps.
"While past budget negotiations have generally been uncontentious, recent political rancor may make bipartisanship difficult to achieve," he wrote.
The unresolved limited-tax GO debt in the Detroit bankruptcy workout remains an issue for Hayes.
The debt provides the bulk of financing to Michigan locals, but has not yet been resolved — even as the city agreed to pay unlimited tax GO bondholders about 74% of the $388 million owed to them.
"Given its budget surplus, it is curious that Michigan is not doing more to support its local governments," Hayes wrote.
Meanwhile, Hayes said there is growing concern in the tobacco sector due to the popularity of e-cigarettes and larger-than-expected declines in tobacco consumption.
Bondholder payments are based on cigarette consumption and assume annual declines below 3%, however consumption declined by 4.8% in 2013, he pointed out.
"These trends could portend credit problems in later years since principal payments on tobacco bonds are not mandatory until the first-term maturities — usually 15 years after issuance," Hayes explained.
