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After a dismal start to the year, few asset classes have rallied as much as municipal bonds.
The iShares S&P National AMT-Free Municipal Bond fund has gained 10.6% this year, while the average intermediate municipal-bond fund gained about 7%, more than the average intermediate government bond fund, which gained 6.1%, according to Morningstar.
A number of factors are behind the strong numbers. The wave of defaults that had been predicted at the beginning of the year have yet to emerge; municipalities issued far fewer bonds than they had in previous years, placing a premium on those that did come to market; and Treasury yields plummeted, pulling the yields of all safe-seeming bonds lower with them. And even a pair of potentially devastating events"”the bankruptcy filing of Jefferson County, Ala. and the spike in European government bond yields"”haven’t caused investors to start selling.
So what could derail this feel-good story in 2012? Here are a few thoughts:
The Mainstreaming of Chapter 9 Bankruptcy: Most observers have always thought of Chapter 9 bankruptcy as something to be avoided. The process is interminable"”Vallejo, Calif., only emerged from bankruptcy this year after filing in 2008"”and it usually doesn't solve the financial problems that got it there in the first place. But when Jefferson County, Ala., filed for Chapter 9, it “headed in a more interesting direction than the market would like,” wrote Municipal Market Advisors' Matt Fabian and Lisa Washburn in a Nov. 21 note. The insolvent county has filed “petitions to wrest control of its asset s from the receiver and the trustee,” they wrote, that "if approved by the court, would only encourage other issuers to seek protection under Chapter 9.” The end result, they say, could end up hitting revenue bonds particularly hard if investors and portfolio managers decide they should be discounted for the risk of more Chapter 9s.
Issuance: Municipal issuance plummeted this year. RBC Capital Markets predicts that new volume will come in between $275 million and $285 million in 2010, 35% lower than in 2010. But don't look now: RBC expects issuance to jump back to more normal levels in 2012, about $340 million. The impact of the new issuance is unclear. If rates stay low and investors go hunting for yields, municipal bonds could benefit. But watch out if financial-market chaos keeps buyers on the sidelines.
The Volcker Rule: In a report issued on Nov. 20, Citigroup argued that the Volcker Rule could have some negative implications for municipal bonds. Market participants assumed that the rule"”which would limit the bets banks can make on financial markets with their own money"”would have limited impact on the muni market. They were wrong. The proposal appears to impose trading regulations on more than half of the municipal-bond market"”including many revenue bonds, Citi's analysts wrote. They make the case that without banks’ participation as propietary traders, bid-ask spreads would widen and yields on new issues would have to be sold with higher yields, as the market would be far less liquid.
Unclear from the report is just how big a role prop traders play in the muni market"”and whether this is just fear-mongering by a U.S. investment bank or whether investors should worry about their revenue bonds.
What’s your forecast for muni bonds in 2012?
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My forecast for the muni bond market in 2012? Whatever is the opposite of Meredith Whitney’s forecast!
Total Return covers the latest personal-finance and investing news and trends, helping readers make sensible money decisions in a complex financial world. Send your comments, feedback and questions to totalreturn@wsj.com.
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