Most investors agree that municipal bonds in 2012 will not match 2011's robust returns. But there are opportunities at various points in the yield curve and among lower investment-grade credits.
Because interest rates are expected to remain low by historical standards and the U.S. economy is showing signs of improvement, muni supply should increase in 2012. (It was down 30% in 2011.)
The macroeconomic forces at work in the U.S. and Europe that continue to spread volatility and general uncertainty should also create opportunities in 2012.
It will be the U.S. economy and the Federal Reserve that will mostly set the table for muni performance, according to Andrew Hofer, managing director in institutional fixed income at Brown Brothers Harriman & Co.
Total return — yield plus or minus change in value — will be driven by the kind of dynamics that pushed Treasury and municipal yields lower in 2011.
"If Europe cleans up its act, you have higher interest rates," Hofer said. "If Europe devolves, you could have a big rally at the long end. And that will really determine whether you'll get a double-digit return on a long muni, as opposed to credit dynamics."
Credit concerns, which dominated the municipal market at the beginning of last year — see Meredith Whitney's muni call late in 2010 — have diminished as state and local governments have taken strong medicine to get their finances in order.
Still, there's a strong potential for interest rates to stay low and finish close to where 2011 ended, industry pros say. But 2012 also has the potential to be a rocky year, considering Europe's malaise, the upcoming presidential election, and potential moves against munis' tax-exempt status, which could cause swings in interest rates.
"We should hold at these levels for a while," said Douglas Gaylor, a portfolio manager for Principal Global Investors. "Interest rates could be a little higher by the end of the year. But you'll still get a lot of income off of your holdings."
Looking ahead, investors will be buying munis for income more than for capital appreciation, according to John Dillon, chief municipal bond strategist for Morgan Stanley Smith Barney.
"For 2012, it's a coupon-clipping endeavor for high-grade munis, like your triple-As and double-As," he said. "You can get total return in your A-rated paper, due to spread compression."
Municipals ended 2011 on a high note. The 10-year triple-A dropped to a record low of 1.83%, muni bond mutual funds strung together four weeks of strong inflows, and the sector as a whole returned 10.7%.
Munis had an outsized year due to factors that just are no longer present, Dillon added.
For one, demand for munis cooled following the expiration of the Build America Bond program at the end of 2010. Also, Meredith Whitney's "muni Armageddon" theory around that time daunted investors and trimmed prices. Finally, economic data had improved in early 2011 to the point where yields pushed higher, setting the stage for gains.
"Now, all three of those factors are history," Dillon said. "That set us up for a nice rally."
This year started with a buy recommendation from no less than bond legend Bill Gross, founder, managing director, and co-chief investment officer at PIMCO.
Gross recommended buying munis in his January 2012 investment outlook. He included the caveat that investors should avoid those municipalities with pension or funding issues.
Doing the research is more crucial to investors than ever, according to Gary Gildersleeve, portfolio manager and partner at Evercore Wealth Management. The market has become much more credit-oriented, he said. It's no longer sufficient to study the ratings alone.
"It's like buying a stock," Gildersleeve said. "In fact, it always has been this way. But we've needed the environment we've had over the past three years for everyone to really appreciate this fact. You have to do your research; you have to know what you're getting involved in. You can't just ask for say, a double-A-rated bond. That's asking for trouble."
So where should people look for value or return?
Gildersleeve finds relatively attractive returns in intermediate-sized offerings, say in the $25-$75 million range.
Typically these hail from strong issuers who don't come to market regularly, but enough so that information on them is available.
Brown Brothers Harriman looks for value in sectors where investors are demanding higher yields, such as health care. Health care reforms and budgetary issues at the federal and state levels have caused some investors to abandon the sector, leaving many opportunities for bottom-up investors.
Many world-renowned and well-regarded hospitals have more endowment funds than debt and are attractively priced, said S.K. Shin, a vice president in institutional fixed income at the firm.
Morgan Stanley's Dillon still likes the six- to 14-year range on the muni curve. U.S. economic data has improved from what the firm expected just a few months ago.
But if the economy should slow, he said he'd be more interested in exploring the 15- to 20-year range.
Principal's Gaylor sees value out at the longer end of the curve. He also sees minimal risk in the triple-B- to single-A range.
Dexter Torres, a principal and head trader on the portfolio management team at Samson Capital Advisors, notes that the firm typically traffics in the short and intermediate part of the curve — mostly 12 years and less.
However, Torres has seen some investors at the firm and elsewhere picking spots within the muni curve, such as buying late 2020, versus early 2020, to take advantage of the steepness of the intra-year curve.
