What’s driving the quiet rally in tax-free muni bonds


Call it a stealth rally in municipal bonds. The asset class often favored by wealthy investors for its tax perks is bouncing back in 2014 despite well-publicized concerns over finances in Detroit and Puerto Rico.

Indeed, the $3.7 trillion municipal bond market may have a pulse after all. After years of strained state and city budgets, some spectacular defaults and muni bond fund outflows, things are finally starting to look up for this fixed-income sector.

The municipal bond market registered gains in March for the first time in six years and advanced about 3.8% for the first quarter. That’s the best quarterly showing since the first three months of 2009, when munis delivered a 4.4% return.

iShares National AMT-Free Muni Bond ETF (MUB)

MUB Chart

MUB data by YCharts

While it’s a little early to declare a sustained recovery, muni market conditions have clearly improved. That’s in stark contrast with expectations at the start of 2014, when Morgan Stanley forecast a 4% decline for munis, assuming that as interest rates rose these fixed-income securities would get clobbered.

Such dire predictions haven’t panned out. For starters, city and state finances are improving, making muni debt far more attractive than last year when bond defaults in Detroit and economic troubles in Puerto Rico prompted investors to flee the muni market.

Enticed by an improving economic outlook and the tax advantages of many muni bonds, investors are starting to return. The income thrown off by muni bonds is exempt from federal taxes.

Pressure to cut local budgets is easing up, thanks to property-tax collections that are rising at the fastest clip since the U.S. housing market crash sent government revenue into a freefall.

In the last quarter of 2013, property-tax collections nationally rose to $182.8 billion, the highest mark in four years. If the tax flows into state and city coffers continue, muni bonds will be viewed as less risky by investors. In theory, that would drive down yields and increase bond prices.

Another positive development: The oversupply of muni paper seen in previous years seems to be easing. New issuances have leveled off and a tighter supply has also supported the price of munis.

On April 11, Morgan Stanley revised its negative view on muni bonds in a note to clients. Citing improved tax receipts and investor interest, Morgan analysts concluded that “all in, the muni market appears to have a better tone to it than a month ago.”

Last November, Matthew Pierce, founder and portfolio manager at Island Light Capital, which manages the Income Portfolio on Covestor’s platform, made the case for munis before the recent rally.

“We use muni bonds in taxable accounts,” said Pierce. “We like the relative safety of muni bonds compared to corporates, and they can make sense when Treasury yields are low.”

DISCLAIMER: The investments discussed are held in client accounts as of March 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. The information contained in this article is general in nature and not intended as specific advice. Neither Covestor Limited nor its representatives are engaged in rendering tax, accounting or legal advice. A qualified professional should be consulted regarding the effect of such considerations on the matters covered in this article.  Past performance is no guarantee of future results.