With interest rates set to rise, many on Wall Street wonder if the municipal-bond market is in for another pummeling as 2014 gets under way.
Investors couldn’t get out fast enough last year. Bonds from states, cities and counties suffered their worst annual performance since 2008 and only their fourth losing year since 1990. The nearly $4 trillion market, a favorite of mom-and-pop investors for their relative safety and tax benefits, seemed to get hit from all sides.
Wall Street was spooked by talk the Federal Reserve would put an end to the easy-money policies that helped propel stocks to new heights. That was compounded by the fallout from a handful of municipal bankruptcies, including Detroit, the biggest in U.S. history.
The result: $48.5 billion was yanked from muni-bond funds in 2013, according to researcher Morningstar.
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“People thought munis were a good place to hide, and they’re finding out you can lose money in munis in a rising interest-rate environment,” said Darell Krasnoff, managing director at Bel Air Investment Advisors in Los Angeles.
“We wouldn’t avoid them,” Krasnoff said. “We use them. But we use them for a role and we have less of them today than we did a couple of years ago.”
The Standard & Poor’s municipal-bond index fell 2.6 percent in 2013, according to S & P Dow Jones Indices.
Some analysts predict another drop this year as rising interest rates weigh on all sorts of fixed-income investments. Morgan Stanley, for example, says it’s likely muni funds could decline as much as 4 percent this year as interest rates move higher.
That doesn’t mean all is doom and gloom for longtime muni investors.
The municipal market has rebounded well from tough times in the past. The market fell in 1994 when interest rates soared. It got hit in late 2010 after a prominent analyst predicted a spate of defaults that never materialized.
Bulls point out that the muni market has several factors going its way and that its long-term prospects remain solid.
The performance of muni funds this year will depend heavily on the speed and intensity of any increase in rates. A gradual rise over time that’s carefully stage-managed by the Fed is likely to do only modest damage to the market, bulls say.
And, of course, an uptick in yields will pay off in the long run for investors, who have been squeezed by years of measly rates.
“They were crying when rates were too low,” said Marilyn Cohen, president of Envision Capital Management, a Los Angeles firm specializing in bonds for retail investors.
“Will they be crying when rates go up? I think it’ll be faint cries,” she said. “There won’t be too much wailing. They need higher rates to live on.”
Beyond that, the fear of municipal defaults is way overdone, analysts say. Munis also could be helped by a reduced supply of bonds and possible new sources of demand.
Fewer new securities are expected to be issued this year as rising rates choke off refinancings of previously issued bonds.
Demand also could be stoked by, of all things, health-care reform. Many couples with adjusted gross income above $250,000 are subject to a new 3.8 percent tax on investment profits to help pay for the new law. Income from muni bonds is exempt from the new tax.
“There’s going to be a wake-up call where people say, ‘Whoa, I don’t want this additional taxable income,’ ” said Dan Genter, head of RNC Genter Capital Management in Los Angeles.
A pronounced setback in the stock market also could push some investors into munis. Even if the muni market has an off year in 2014, any losses would pale in comparison with the damage that could be suffered in stocks.
Munis are popular with small investors, particularly the wealthy.
The poor performance of muni funds last year is a turnaround from their steady gains over much of the last decade, when their returns were goosed by principal gains stemming from falling interest rates.
Munis have overcome concerns in recent years amid the financial problems of Detroit and a handful of other cities, including Stockton and San Bernardino, Calif.
Even though Detroit defaulted on some of its general-obligation bonds, municipal defaults are at low levels as the improving national economy boosts tax revenue for cities.
The biggest threat to munis is an expected climb in interest rates.
Rising rates cause older bonds paying lower yields to fall in value. Even though a fund earns slightly higher yields on new bonds it buys, the market value of all its older securities declines.
The entire bond market got walloped last summer when the Fed hinted at an end to its economic stimulus program, which had kept a lid on bond yields. The S&P muni-bond index slumped 7 percent in four months.
The central bank in December announced a so-called tapering of its monthly purchases of Treasury and mortgage bonds to $75 billion from $85 billion. It may eliminate all its bond buying by the end of 2014.
The fixed-income market reacted far more calmly, but interest rates have continued to inch up. The yield on the benchmark 10-year Treasury note eclipsed 3 percent in late December, its highest level in 2½ years.
Some experts think munis could be especially susceptible to pain. Yield-hungry investors crowded into them in recent years, causing the market to become overvalued.
“While all fixed-income markets are sensitive to changes in interest rates, munis have developed an outsized vulnerability,” Michael Zezas, Morgan Stanley’s chief municipal strategist, wrote in a recent report.
“In recent years, muni performance binged on lower rates moves, an improving credit story, and investor thirst for yield,” he wrote. “This resulted in valuations that amplified munis’ vulnerability to higher rates.”