Can Muni Bonds Sustain Recent Gains?

November 17, 2014 Updated: November 17, 2014

One of the least glamorous investments has been on a tear this year.

Year-to-date returns on municipal bonds, or debts issued by state or local governments to finance capital expenditures, have exceeded expectations in 2014 after taking a beating last year. Muni bonds have posted their longest string of consecutive monthly gains in more than 20 years. 

As of last Friday, the S&P Municipal Bond Index had total returns (appreciation and interest) of 8.24 percent year to date. These figures outpace the Dow Jones blue chip stocks (up 6.4 percent), the Barclays U.S. Treasury index (4.21 percent), and the benchmark Barclays U.S. Aggregate investment-grade corporate bond index (5.19 percent).

Consider the fact that muni bonds are exempt from federal income tax, and state income tax as well, if you own bonds issued locally—and the total returns are even higher.

Current year performance by muni bonds is a complete reversal from 2013, when the sector suffered from a 2.6 percent decline following Detroit’s Chapter 9 bankruptcy and Puerto Rico’s debt crisis. 

The muni bond rally has enabled municipalities to lower borrowing costs and fund infrastructure projects. The boom especially benefits lower-rated issuers. Puerto Rico raised $3.5 billion this year, while Atlantic City, N.J., issued $241 million in notes backed by hotel and alcohol consumption taxes.

Analysts Divided on Future

But some experts said muni bonds’ luck may soon run out. Citigroup analysts wrote in a research note last week that they see 2015 as a tough year for muni bonds.

“Munis had a strong year, but the going will likely get tougher—valuations are getting unappealing, in our view,” Citigroup said. The bank cites rising Treasury yields, higher interest rates, and unappealing muni-to-Treasury yield ratios as possible scenarios for munis to underperform. 

Morgan Stanley worries about an oversupply of muni issuances. “The more robust slate of primary supply may place us just one weekly fund outflow away from underperformance versus [U.S. Treasuries],” the bank wrote in its fixed income strategy monthly note.

Analysts use U.S. Treasury bonds as a relative benchmark to evaluate muni bonds. Both are backed by tax revenues but muni bonds are far riskier. The assumption is that Treasuries are essentially “risk-free,” and given the still-precarious financial position of many state and local governments, a tight spread between Treasury and muni bond yields signals that muni bonds are overbought.

Bank of America, on the other hand, doesn’t buy the overbought story, especially for investors seeking tax efficient gains. “Even though muni ratios to Treasuries are now at their lows for the year, they are far above any tax efficient level and do not reflect the sunset of the Bush tax cuts and the Obama health care tax. … For high income individuals, especially, muni’s continue to offer windfall gains.”