Investors Cautious on Muni Market, Eye Washington

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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 environment?"

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. (Read More: Lawmakers Struggle to Break 'Cliff' Stalemate)

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 health care, 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 Securities.

"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.