Municipal bonds are back in favor after their drubbing in 2013.
Investors are being lured back by relatively high yields, especially after tax breaks on much of the debt issued by states, cities and local-government entities are taken into account.
Amid a selloff in all types of bonds last year, and a corresponding climb in yields, munis were among the worst performers, due partly to Detroit's filing for bankruptcy protection and financial troubles in Puerto Rico. Fears that trouble in some corners would bleed into the broader $3.7 trillion muni market have ebbed, and many investors are taking the opportunity to pick up some bonds on the cheap. Bond yields and prices move in opposite directions.
"I don't see a big fear factor anymore," says Duane McAllister, a portfolio manager at BMO Asset Management, which oversees $100 billion.
Since Jan. 2, investors have poured $925 million into municipal-bond funds focused on debt that is exempt from certain taxes, according to data provider Lipper based on funds that report weekly. Inflows have been notched for six of the past seven weeks. This contrasts to the 33 consecutive weekly outflows that resulted in a net outflow of $64 billion—a record—for all of 2013, including funds that report on a monthly basis.
Even bonds from financially stressed municipalities have rallied. The yield premium that investors demand for holding 10-year Illinois debt has shrunk to 1.2 percentage points over the yields on the most highly rated munis, according to Thomson Reuters Municipal Market Data. That is the smallest spread since June 2010 and is down from about 1.7 percentage points in November.
In December, Illinois lawmakers agreed on reforms to the state's retirement system, easing investor concerns about the state's unfunded pension liabilities. Even after the rally, Illinois still has the highest borrowing costs of any U.S. state.
Pension reforms aren't the only signs of progress cheering investors: The budget outlook for many states and cities has been strengthened by belt tightening and higher-than-expected tax revenue largely due to the economic recovery. This makes Detroit and Puerto Rico look more like isolated cases, investors say.
As bad news has abated, sentiment has improved among the mom-and-pop investors who buy up more than half of muni sales, experts say.
Helping matters is stabilization in Treasurys, which act as a benchmark for global bond markets. Treasury yields soared last year when Federal Reserve officials began to signal they were preparing to wind down a bond-buying program that had supported the market. But yields have since retreated after several mixed reports on the health of the U.S. and global economy. The yield on the 10-year Treasury was 2.66% Friday, down from 3.03% at the end of 2013.
"After a bludgeoning in 2013, risks in the market are fairly valued," said Chris Ryon, a portfolio manager at Thornburg Investment Management, a $94 billion asset manager that has been purchasing longer-term and lower-rated munis.
In December, Mr. Ryon bought debt of the California Pollution Control Financing Authority with a 2045 maturity at 79 cents on the dollar. Moody's Investors Service rates the debt at Baa3, the lowest rating for an investment-grade bond. The bonds traded at 95 cents on the dollar Friday, according to the Municipal Securities Rulemaking Board's website.
The rally in munis has outpaced the rise in other bond markets as investors looked to lock in the relatively high yields that emerged from last year's selloff.
In August, the month after Detroit filed the largest municipal-bankruptcy filing by amount of debt, the highest-rated 30-year muni bonds were yielding 0.76 percentage point over comparable Treasurys. In recent days, the spread has narrowed to as low as 0.11, according to Thomson Reuters MMD.
As a result, munis are handing fixed-income investors some of the biggest returns. In 2014 through Feb. 27, munis have returned 3.07%, which includes price appreciation and interest payments, according to Barclays. That beats out gains in Treasurys, mortgage bonds and corporate debt. In 2013, munis posted a negative return of 2.55%, the worst since 1994.
To be sure, some fund managers say munis' recent outperformance has more to do with meager bond issuance rather than an improvement to municipalities' fiscal outlook.
Bond sales have slowed. Municipalities have issued $31.6 billion of debt so far this year, down 32% from the same period in 2013, according to Thomson Reuters. At the same time, investors received about $60 billion in coupon payments and redemptions in January and February, and it is becoming more challenging to deploy that cash, said Chris Mauro, head of municipals strategy at RBC Capital Markets.
The pace of municipal issuance typically picks up in March, Mr. Mauro said. March sales have represented about 9% of annual issuance in past years, which would put the month's volume at about $25 billion, based on his estimates.
"Having had the kind of rally that we've had, it will be interesting to see if the market can sustain a significant increase in volume," said Joe Deane, head of municipal bonds at Pacific Investment Management Co., a unit of German insurer Allianz SE that oversees $1.91 trillion in assets. Given how much yields have fallen already, it could prove difficult to further whet investor appetite at current yield levels, he added.
Mr. Deane also said he believes that munis now border on expensive after becoming "very cheap" in 2013. Pimco has become "a little more conservative" and in some instances is staying in cash instead of putting on more muni-bond bets, he said.
Still, some money managers say munis are becoming more alluring to some investors thanks to the tax-exempt status of many bonds. Interest from munis is often exempt from federal taxes and, in some cases, is free from state and local taxes as well.
As they file tax paperwork for 2013, investors are facing a higher top rate for long-term capital gains and a new net investment income tax.
"We're hearing anecdotally that taxes are higher than [people] thought they'd be," said Kenneth Potts, a fund manager at Samson Capital Advisors, which manages $7.1 billion. In that circumstance, he said, "munis are one of the first places people think about."