Trusted performance.  Lasting value.

Stage set for rally in municipal bonds

By Jason Kephart

May 6, 2012 6:01 am ET

This could be a hot, dry summer for municipal bonds, as demand for new issues is anticipated to outstrip supply and drive up prices.

RBC Capital Markets projects that municipalities will return approximately $140 billion to municipal bond holders through distributions and return of principal over the next four months, while issuing only $120 billion in new bonds, leaving a $20 billion reinvestment gap, which it called a “dramatic supply/demand mismatch” in a research note issued last week.

J.P. Morgan Securities LLC projects an even larger gap — $29 billion — the equivalent of about 10% of the $300 billion municipal bond fund market.

“There is a lot more demand than supply right now, and it’s just going to get more severe over the summer,” said John Miller, chief investment officer at Nuveen Investments Inc.


The supply shortage continues a trend that began last year when net new issuance of municipal bonds slowed. While the total volume of municipal bonds issued through April is almost double what it was over the comparable period last year, more than two-thirds of the deals have been refinances, leaving the net number of new municipal bonds available falling short yet again.

“It’s a function of the fact that smart municipalities are cutting back,” said Ronald Bernardi, president of Bernardi Securities Inc., a municipal bond broker-dealer.

Another driver of demand is the possibility of higher taxes after the November presidential election.

“The overall demand, coupled with the potential for tax in-creases, is making municipals attractive,” said Chad Carlson, a wealth manager at Balasa Dinverno Foltz LLC.

Some advisers are being more cautious, however, given last summer’s municipal bond rally.

“There’s just not a lot of juice left in that orange,” said Brian Kazanchy, chairman of the investment committee at Regent Atlantic Capital LLC. “Municipals could continue to do well, but they’ve just gone up so much already.”

Demand for municipal bonds was so strong last summer that the asset class posted an 11% return for the year, second only to the performance of Treasuries. That run has continued this year, with the S&P Municipal Bond Investment Grade Index, a popular benchmark for municipal funds, posting a return of 2.28% through the end of April.

While a record-low supply of municipal bonds was partly the reason for last year’s rally, the real driver was a surge of demand after the stretch from November 2010 to May 2011 during which a record $43 billion was withdrawn from muni bond mutual funds. During that period, when redemptions forced sales on the broad but very illiquid muni bond market, the average muni bond fund was down 2.5%.

The impetus for the withdrawals, of course, was analyst Meredith Whitney’s highly publicized prediction that billions of dollars of municipal bonds were in jeopardy as municipalities teetered on default. When those predictions failed to materialize, money started to flow back into municipal bond funds, which fueled last year’s rally.

Even though the crisis in confidence seems to have passed, investors have returned only about $30 billion of their $43 billion in net outflows.


The performance of municipal bonds, more than any other asset class, rests on the mechanics of supply and demand, because about three-quarters of the market is owned by retail investors, said John Mousseau, a managing director at Cumberland Advisors LLC, a wealth management firm that oversees more than $2 billion in assets. “The tax-free space is so dominated by individual investors that it makes it very susceptible to swings in flows.”

While the unique supply-and-demand characteristics of municipal bonds paint a rosy fundamental picture for the asset class, munis remain susceptible to rising interest rates. If Treasury yields start to tick up this summer, new tax-free bonds will have to follow suit, translating into a loss of principal for existing bonds.

An alternative risk, of course, is if munis rally and yields decline, investors looking to the bonds solely for income may be disappointed.

Managing an investment portfolio in today’s volatile financial markets requires sophisticated financial tools.