What a difference a year makes. Twelve months ago, banking analyst Meredith Whitney predicted that 2011 would bring “hundreds of billions of dollars” of municipal bond defaults due to intense fiscal stress on states and local governments.
What a difference a year makes. Twelve months ago, banking analyst Meredith Whitney predicted that 2011 would bring “hundreds of billions of dollars” of municipal bond defaults due to intense fiscal stress on states and local governments.
But anyone who acted on the ominous forecast she delivered on CBS' “60 Minutes” in December 2010 missed out on an impressive rebound in the nearly $3 trillion municipal bond market. Muni bonds generated an average return of about 10% in 2011, according to the Barclays Capital Municipal Bond Index.
That stunning return hammered equities, which were flat for the year through late December, as measured by the S&P 500.
Analysts don't expect municiapl bonds to match their 2011 performance, but they are still bullish in the asset class.
“Assuming economic growth stays slow, and the Federal Reserve keeps interest rates low, municipals won't diverge too much from the pattern we had in 2011,” said Matt Fabian, a senior analyst at Municipal Market Advisors Inc.
Predictions of a large number of defaults last year weren't reasonable in the first place, several analysts said.
Even though the biggest government bankruptcy in U.S. history was filed in November by Alabama's Jefferson County, the annual average 10-year borrowing cost for top-rated state and local governments ended the year at about 2%, according to a Municipal Market Advisors index. That is at the lowest rate since the firm began collecting data in 2001.
Municipal bonds were in high demand in 2011 with only a modest number of new issues available, Mr. Fabian said. Aggressive buying by banks accounted for some of the demand pressure as depository institutions looked for opportunities to put capital to work beyond the residential and commercial real estate markets, he said.
This year, muni bond yields could hit new record lows as continued demand puts pressure on a limited supply of new issuances. States and localities will continue to work on balancing their budgets and are unlikely to engage in many new infrastructure projects, Mr. Fabian said.
Anthony Valeri, a fixed-income investment strategist for LPL Financial LLC, said he expects 2012 will be positive for municipal investors, though probably not as profitable as last year.
“The near-record-low yields may keep people on the sidelines or even encourage some to get out and take profits,” he said. “That limits the potential.”
He said he expects returns of about 3% to 5%, though certain circumstances could spark additional buying.
The national discussion about raising taxes could boost demand for tax-exempt muni bonds, Mr. Valeri said. Of course, if last year's discussion by the congressional deficit-cutting supercommittee about eliminating the tax exemption on municipal bonds is revisited, that could affect the market, too.
Taxing the interest on bonds issued by thousands of states and municipalities would raise their costs at a time when borrowing expenses need to remain low, analysts said.
Mr. Valeri said he's not concerned that such a proposal would really move forward, especially during an election year.
“[The muni tax exemption] doesn't cost the federal government that much, and they still need an attractive vehicle for state and local government financing,” he said.
Ben Thompson, managing principal and chief executive of Samson Capital Advisors LLC, agrees that taxes “are a wild card” going into 2012.
The tax conversation is going in opposing directions, with Democrats generally calling for tax increases and Republican presidential candidates offering proposals with the opposite impact, such as Newt Gingrich's plan to create an optional 15% flat tax, a per-person deduction of $12,000 and a drop in the corporate tax rate, in addition to allowing businesses to write off capital expenses and eliminate capital gains.
NEWS AROUND TAXES
“It's an election year and taxes are ... important ... and news around taxes is a variable that could swing dramatically in either direction,” Mr. Thompson said. “If all marginal tax rates fall, then munis could become less attractive.”
On the supply side, according to Mr. Thompson, there won't be much of a change from the aggregate worth of new municipals issued in 2011, which he estimated at $280 billion.
“States and localities are increasing their attention to fiscal responsibilities,” Mr. Thompson said. “That's reducing expectations for capital expenditures.”
The U.S. economy still isn't growing “by leaps and bounds,” so tax revenue will be stable, requiring municipalities to live within tighter budgets, Mr. Thompson said.
“It looks like 2012 will have the tail wind of positive investor sentiment,” he said. “But municipalities will still have tight budgets.”
Financial adviser Jim Karabas, managing director of Vestor Capital Partners LLC, said the tax benefits of municipal bonds make them great investments for clients in high tax brackets. He said he could envision using even more of them if taxes rise for the wealthy, as President Barack Obama and Democrats in Congress have advocated.
Mr. Karabas said he is cautious and only invests in high-quality bonds, mindful of the financial difficulties that some states have had and the perilous situation that Ms. Whitney envisioned for 2011.
“Sometimes, the taxable bonds are paying so much more that it makes more sense to look at those,” he said. “We are constantly watching the spread.”
lskinner@investmentnews.com
