Citigroup Leads Selling Chorus After Calling Rally: Muni Credit

Apr 25, 2014 7:23 am ET

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April 25 (Bloomberg) -- Citigroup Inc., which correctly predicted this year’s municipal-bond rally, is leading a chorus of investors and analysts saying the gains are nearing an end.

State and local debt has earned 5 percent this year through April 23, the best start since 2009 and rebounding from a 2.9 percent loss in 2013, according to Bank of America Merrill Lynch data. With benchmark yields setting 10-month lows, leaving the bonds close to the costliest relative to Treasuries since January 2013, it’s time to sell, said Mikhail Foux, a credit analyst at Citigroup.

“You just cannot find a lot of value in munis at current levels, while you could see a meaningful move higher in yields,” Foux, who’s based in New York, said in an interview. “All the gains you’ll have this year, you’ve had already, and you’ll probably give some of them back.”

Investors have a reason to listen to the strategists at the nation’s third-biggest bank by assets. The group said in a Jan. 8 report that the forces behind 2013 declines were “already played out” and that munis were set for “a modest positive total return.”

Vanguard Concurs

Chris Alwine at Vanguard Group Inc., Hugh McGuirk at T. Rowe Price Group Inc. and John Dillon at Morgan Stanley Wealth Management share the view that interest rates for munis and other fixed-income assets will rise as the economy recovers.

The median forecast in a Bloomberg survey of 55 analysts is that 10-year Treasury yields will be about 0.9 percentage point higher in a year. In 2013, the interest rate jumped about 1.25 percentage points. Yields have fallen this year on lackluster job growth and turmoil in emerging markets.

Munis have outpaced Treasuries and corporate debt in 2014, in part because the $72 billion of state and city issuance this year is the slowest since 2011, data compiled by Bloomberg show. Munis are poised to log four straight months of gains to start the year for the first time since 1991, Bank of America data show.

“The strength of this move in the first quarter and April is a little surprising, but the technical environment has been very favorable,” said McGuirk, Baltimore-based head of muni investments at T. Rowe Price, which oversees about $20 billion of local debt. “I was figuring zero return for this year.”

Evaporating Value

Munis look even costlier in relative terms. The interest rate on AAA 10-year debt is 2.38 percent, compared with about 2.7 percent on benchmark Treasuries. The ratio of the yields, a gauge of relative value, is about 89 percent, close to the lowest in 15 months.

The smaller the figure, the more expensive munis are in comparison.

“We have really seen a lot of the cheapness evaporate,” said Alwine, head of munis at Valley Forge, Pennsylvania-based Vanguard, which oversees $130 billion of local debt. “Most of the excellent performance we’ve seen for 2014 is behind us.”

While the consensus is for interest rates to climb, rising federal tax rates may bolster local debt. On April 15, some top earners faced levies on debt interest payments that were as much as 24 percent higher than in 2012.

Phil Fischer, head of muni research in New York at Bank of America, said in an interview that “the tax rate shock has just started to sink in,” stoking demand.

Making Sense

Tax-free bonds “still make a lot of sense” when compared with fixed-income alternatives, said James Dearborn, head of munis in Boston at Columbia Management Investment Advisers, which oversees about $30 billion in local debt.

The benchmark 2.38 percent muni yield equals a 3.94 percent taxable rate for investors in the highest federal tax bracket.

The flow of cash suggests the tax-haven argument is winning. Individuals have added assets to muni mutual funds in 12 of 16 weeks this year, Lipper US Fund Flows data show.

State and local debt typically benefits from increased demand after individuals pay taxes, rallying in May in all but five years since 1989, Bank of America data show.

Yet history also shows that investor sentiment can change direction in a matter of days.

Muni mutual funds saw $311 million of inflows in the week through Dec. 12, 2012, when tax-free yields fell to the lowest level since 1965. The following week, investors yanked $2.3 billion, the largest outflow in 23 months. Interest rates haven’t returned to their lows since.

“The investor mentality is like the herd mentality -- people typically like to buy when prices are high and sell when prices are low, and that’s what we have right now,” Citigroup’s Foux said. “I don’t think there’s a lot more juice in munis.”