NEW YORK, Nov 2 (Reuters) - The typically steady-as-she-goes U.S. municipal bond market is beginning to tread on shaky ground, with continuous mutual fund outflows, weaker prices and rising supply in recent weeks.
That, coupled with an expected bump in year-end tax-loss selling, has made participants cautious in the roughly $3.85 trillion market where states, cities, schools and other issuers sell debt.
"On the munis side of things, there have been some challenges and we've seen some of those challenges in the last few weeks," said Peter Hayes, head of BlackRock's Municipal Bonds Group.
Rising interest rates and inflation concerns have been alarming investors, while potential volatility tied to the outcome of the U.S. congressional elections next week has also kept market participants on their toes. Added seasonal selling of municipal bonds through the end of the year is fueling yield increases.
In the week ended Oct. 31, muni fund net outflows totaled $1.3 billion, the largest since December 2016, following five consecutive weeks of negative flows, according to Lipper data released late on Thursday. Year-to-date, the S&P Municipal Bond Index was down 0.88 percent.
Through the end of the year, the muni market could see an uptick in investors selling their holdings at a loss as a way to offset tax obligations for gains in other more profitable asset classes, like equities, Hayes said.
Supply of new bonds has started to increase in the last few weeks, after sluggish issuance for most of 2018. However, this latest increase is being met by slipping demand.
"All of those things mean that it will probably take slightly higher yields in order to clear all that paper," Hayes said.
Signs of weakness in the muni market emerged in early October as investors fixated on Federal Reserve rate hikes and inflation fears.
Large moves up in rates are generally a precursor to outflows, said Barclays municipal credit analyst Mikhail Foux, adding: "And that's what we have this year."
Foux said he is watching rates and eyeing next week's election results.
"For the remainder of the year, I would expect to see probably some volatility in the immediate aftermath of the midterms," he said.
If Democrats take control of the House of Representatives or the Senate, the potential for a large infrastructure bill could increase to about 50 percent, Municipal Market Analytics wrote on Twitter on Friday.
Signs of dimming demand are also becoming evident in the market.
Bids-wanted totals increased starting in October, indicating a rise in the number of holders of municipal bonds wanting to sell.
The shifting dynamics have woken up investors in a market that is generally quiet compared with other major asset classes.
Through the year, muni investors seemed to believe they could keep their portfolios on auto-pilot, said Tom Roseen, head of research services for Lipper.
"I think they're kind of realizing that's not necessarily true," he said. "We're seeing money go. When it does move, we're actually seeing people stretch for yield."
High yield munis have been an outperformer for the year. The last six weeks of muni fund outflows, however, have not spared the high-yield sector.
Longer-dated debt has taken the brunt of the sell-off, while shorter-dated debt has not suffered as much, Roseen said.
Still, munis remain a relatively safe investment compared with other asset classes, Roseen noted.
Year to date, munis have outperformed corporate bonds and U.S. Treasuries, with which the municipal bond market generally moves in sympathy.
(Reporting by Laila Kearney; editing by Karen Pierog, Daniel Bases and Dan Grebler)