Muni Bonds Face Headwind as Governments Borrow Before Tax Change

(Bloomberg) -- A last minute borrowing spree by states and cities may throw a damper on the municipal-debt market’s best annual returns in three years.

Investors and analysts are anticipating a rush to sell billions of dollars of bonds over the next six weeks as Congress’s tax-cut plans propose rolling back a big chunk of the subsidies given to municipal debt beginning in January. That may exert a short-term drag on the prices of the securities, which rallied for most of the year as money kept flowing into the market and new sales slowed from 2016’s record pace.

“The market could absorb it. Would the market cheapen to absorb it? Yes," said John Mousseau, director of fixed income at Cumberland Advisors, which holds $2.4 billion of municipal bonds. “I’m sure everybody that has one on the table is moving it up and everybody who doesn’t is talking to their bankers to move it up." 

Citigroup Inc. analysts this month raised their forecast for municipal debt sales in 2017 by $15 billion to $380 billion. Barclays Plc analyst Mikhail Foux said as much as $25 billion of deals set for next year may be moved up -- a sum roughly equal the entire amount sold during a typical December. About $334 billion of long-term debt has been issued so far this year, according to data compiled by Bloomberg, down from a record $428 billion last year.

That predicted wave is already showing signs of forming. The Metropolitan Transportation Authority, which runs New York City’s subways, is selling $2 billion of debt on Tuesday in case Congress does away with so-called advanced refundings, a frequently used refinancing technique. A Florida agency is also moving ahead with a long-planned $600 million sale for a privately run passenger railroad, a type of project that would lose access to the tax-exempt market under the House’s plan.

The expectations may already be having a modest impact on prices, with yields on benchmark 10-year municipal bonds edging up 1 basis points last week to 2.01 percent even as Treasury prices gained.

Barclays analysts told clients in a report Friday that the expected increase in issuance triggered by tax reform has made them "cautious" about municipal bonds.

"The market has not been truly tested by a spike in supply as of yet, which is expected in the next 2-4 weeks," they wrote. "We remain cautious for the time being, as it is rather hard to gauge the extent of the supply pick-up."

Municipals have returned 5.1 percent this year, more than twice the 2.3 percent earned from Treasuries and on par with the 5.4 percent for taxable U.S. corporate debt, according to Bloomberg Barclays Indexes. 

Analysts and investors aren’t predicting that the borrowing will trigger a steep decline in prices, given that demand has held strong and municipal funds continue to pull in cash. The junk-rated Chicago Board of Education’s sale last week was well oversubscribed, an indicator that there are plenty of buyers for municipal bonds, said Robert Amodeo, who manages about $25 billion as head of municipals for Western Asset Management in New York. 

"If it’s an excess of $10 to $20 billion worth of supply, I think there’s capital there to absorb that," Amodeo said. "I do believe there is enough capital on the sidelines today."

The tax plan’s fate in the Senate is uncertain, and the bond provisions could be changed once the House and the Senate bills are reconciled. But both chambers’ plans would eliminate advanced refundings after Dec. 31. Such refinancings accounted for $120 billion, or 27 percent, of municipal sales last year, according to Barclays.

The market faces other headwinds as the year comes to a close, said Nicholos Venditti, who oversees $11.5 billion of munis at Thornburg Investments in Santa Fe, New Mexico. The Federal Reserve is expected to raise rates at its December meeting and the unwinding of its bond buying program has put pressure on shorter maturity securities, he said.

The market “can’t support the incredibly high prices that we’ve seen recently," Venditti said.

“If you pair that with a lot of additional supply in an uncertain time, it may put some pressure of the curve as a whole," he said. “Until that’s resolved people are less likely to be as aggressive then they’ve been over the previous six months."

--With assistance from Amanda Albright

To contact the reporters on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net, Danielle Moran in New York at dmoran21@bloomberg.net.

To contact the editors responsible for this story: Christopher Maloney at cmaloney16@bloomberg.net, William Selway

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