* Washington policy shifts may be game changer
* Strong muni gains may be ending
* New deals seen rising moderately in 2013
By Michael Connor
Dec 21 America's $3.7 trillion municipal bond
market has been riding up for two years, powered by tax-free
yields that sometimes topped taxable Treasury payouts and a
calming among small investors who had feared local governments
were going to crash and burn.
Even after a muni selloff this month, the rise has delivered
total returns of 18 percent since late 2010. But a further runup
looks less sure in 2013 because of potential federal tax
reforms, low yields that turn off income-seekers, and a dogged
drag on government borrowers from the 2007-2009 recession.
"We have a number of questions and very few answers," said
David Manges, municipals trading manager at BNY Mellon. "How can
rates fall further? How do we handle a rising-rates
And what will Washington do?
That's the biggest question for 2013, according to
institutional investors, analysts and traders.
"It is vitally important to stress that myriad fiscal policy
and tax code changes are possible in 2013, which may
substantially alter the contours of municipal bond performance,"
Morgan Stanley analysts John Dillon and Matthew Gastell said.
Not only are munis possibly facing a game-changing shift in
federal tax-exemption policies on interest payouts, the
securities' main attraction for investors, but they could be
hurt by federal policymakers' desire to slash spending.
Washington policymakers are negotiating furiously to try to
avert automatic spending cuts of more than $1 trillion over a
decade are set to begin on Jan. 1.
But given the political hunger for savings, America's 90,000
state and local governments that get federal monies and
subsidies for operations and capital projects are preparing to
receive fewer dollars from Washington.
Worst hit by the automatic spending cuts, also known as
sequestration, will be cities and counties in New Mexico,
Virginia and elsewhere with workforces built around federal
contractors, military operations or agencies. The down shift in
transfer payments could dull other local economies as well.
U.S. state and municipal governments, which have wrestled
for five years with tight budgets, will soon see tax collections
slow as federal deficit-cutting kicks in and federal dollars
that go to hospitals and universities will dwindle, according to
Janney Capital Markets analyst Alan Schankel.
"We believe ratings downgrades of municipal issuers will
exceed upgrades in 2013, but overall credit quality erosion will
be marginal, with an increase in the pace of default or
bankruptcy unlikely," Schankel said in a report.
PUERTO RICO'S STILL A WORRY
One leading bond issuer, Puerto Rico, will be closely
watched, Schankel said. The Caribbean island's widely held
general obligation bonds were downgraded last week to near-junk
status by Moody's Investors Service.
Other than some sectors, such as healthcare, benefiting from
a tightening of yield spreads, overall muni gains during 2013
will lag 2011 and 2012, Schankel said in a report.
"We see a three-peat as unlikely," he said.
Puerto Rico and other weak issuers would likely be hurt the
most by an overhaul of muni tax-exemption, even by a frequently
mentioned 28 percent cap on the value of the muni exemption,
according to a report by analyst Natalie Cohen of Wells Fargo
"Given the island's recent Moody's downgrade, weak fiscal
condition and sorely underfunded pension, we could envision the
commonwealth facing market access difficulties," Cohen said.
The muni tax exemption has been under threat for more than
two years, with Obama suggesting a cap in his annual budgets and
the limit appearing in legislation during 2011. But the threat
has become more serious in recent months, as a drumbeat for tax
reform grew louder during the 2012 presidential campaign and the
federal government seeks ways to raise revenue.
One policy shift in play in Washington -- an overall end to
tax-exempt muni interest -- would deter road repairs and other
infrastructure spending by raising borrowing costs, especially
for small issuers, Cohen said.
A central driver of the muni market this year has been
buying by small investors, especially those who use mutual funds
specializing in tax-free debt, according to analysts Dillon and
Gastall of Morgan Stanley.
"A string of outflows, which has simply not been the case
this year, could negatively impact pricing in a rapid fashion,"
the analysts said.
Muni bond funds tracked by Lipper have had net weekly
inflows for over a year, except for the weeks ended April 11,
Oct. 31, and Dec. 19.
Despite massive outflows in the latest week, 2012 is on
track to record the second biggest inflows after 2009 in
Lipper's records. Altogether, municipal bond funds have seen
$48.1 billion in net new money during the year-to-date.
Buying by mutual funds helped drive down tax-free interest
rates to record lows posted just weeks ago, a trend that has
encouraged bonds sales by issuers, but may put off
income-seeking investors during 2013.
The bulk of the $367 billion of debt so far this year has
been refundings, in which issuers sell new bonds at low rates
and payoff older, outstanding debt with higher interest rates,
according to Thomson Reuters data. New money issues have totaled
just $142.6 billion.
Looking to next year, many forecasters see at best a modest
increase in total new issues, with estimates from Wells Fargo
Securities at $340 billion in 2013, $325 billion by RBC Capital
and $375 billion from Bank of America Merrill Lynch.
But Loop Capital Markets forecasts $400 billion of primary
deals next year, and the Securities Industry and Financial
Markets Association trade group on Friday said its annual survey
forecasts a 9 percent rise to $458 billion in 2013.