After posting one of their best annual gains since 2011, municipal debt securities, along with related exchange traded funds, may begin to slow down.
The iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB) has increased 9.0% year-to-date and gained 10.3% over the past year. [MuniNation: Crosscurrents May Benefit Municipals]
Now, PIMCO and Morgan Stanley warn that returns in 2015 may be less than half the 8.7% rise in the broad municipal bonds market in 2014 after interest rates likely bottomed out this year, reports Michelle Kaske for Bloomberg.
Michael Zezas, chief municipal strategist at Morgan Stanley, argues that muni market gains will diminish as the Federal Reserve ends its bond-purchasing program and preps for higher interest rates.
“You’ve already run it fairly far,” Joe Deane, head of munis for Pimco, said in the article. “From these levels, to have this kind of a return, you would have to take interest rates down to some dramatic levels. I don’t see that being in the cards.”
Additionally, with investors chasing after this year’s rally, demand has pushed borrowing costs down to generational lows, which could allow municipalities to cheaply increase financing for public works.
MUB now shows a 1.66% 30-day SEC yield, or a 2.93% taxable equivalent 30-day SEC yield.
Meanwhile, yields benchmark 10-year munis have dipped to 2.05%, their lowest since May 2013 after the interest rate declined for three straight quarters. Over the past 13 consecutive weeks, investors have piled into U.S. muni mutual funds, the longest stretch since 2012.
Looking ahead, interest rate risk will likely turn up volatility and push down on muni returns.
“We expect rates to gradually move higher and volatility to pick up as we get closer to a Fed exit,” Zezas added. “Those are things that are a risk in muni performance.”
Consequently, both Deane and Zezas also advice investors to shift out of high-yield municipal bonds and into higher-quality credit after the significant run-up muni debt this year. For instance, the Market Vectors High Yield Municipal Index ETF (NYSEArca: HYD) has increased 13.6% year-to-date and 15.4% over the past year. HYD has a 4.63% 30-day SEC yield and a 7.66% taxable equivalent 30-day SEC yield for those in the highest income bracket. [High-Yield Muni ETF Navigates its way to New Highs]
“With the rally that we’ve had, it just makes us a little more conservative,” Deane said. “If we’re going to put money to work, it’s going to be higher-grade stuff and it’s going to be shorter.”
For more information on the munis market, visit our municipal bonds category.
Max Chen contributed to this article.