Morgan Stanley: Muni Bonds Look Like a Poor Bet in 2014

Friday, 06 Dec 2013 08:05 AM

By John Morgan

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Morgan Stanley's 2014 outlook for municipal bonds is a bleak one, with a base estimate those debt instruments could lose up to 4.1 percent during the coming year,  Investment News reported.

The poor forecast is primarily due to widely held expectations in the marketplace for rising interest rates in the months ahead.

Morgan Stanley Research forecasts that the most likely scenario is for munis to lose between 1.7 percent and 4.1 percent in 2014 because interest rates are likely to go up and the Federal Reserve is expected to start unwinding its massive asset purchases that have kept a lid on rates.

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Bond prices, including those for munis, tend to move in the opposite direction of interest rates.

Michael Zezas, a municipal bond strategist at Morgan Stanley, said rising rates could produce an exaggerated response in the muni marketplace.

"In recent years, muni performance hinged on lower rate moves, an improving credit story and investor thirst for yield," he wrote in a research note. "This resulted in valuations that amplified munis' vulnerability to higher rates."

The firm's worst-case scenario is even darker than its base case. Morgan Stanley Research said there is a 20 percent chance that U.S. economic growth could be stronger than expected, forcing the 10-year Treasury yield over 4 percent. In that case, munis could lose 6.2 percent to as much as 7.8 percent in 2014.

Investment News reported muni bonds are now "in the midst of their worst sell-off ever." November marked the ninth straight month of net outflows, with more than $57 billion pulled out, according to the Investment Company Institute.

Hedge funds are starting to bottom-feed in the muni market, which may not always be favorable for the issuers, The Wall Street Journal reported.

The hedge funds' game plans include demanding high interest rates in return for financing local governments, picking up the debt of hard-pressed municipalities on the cheap and trying to profit on rising volatility as individual investors flee the market, The Journal reported.

In Jefferson County, Ala., which filed for bankruptcy in 2011, hedge fund investors could make a tidy profit of about 33 percent on $900 million of sewer debt they bought at a discount, according to The Journal — a return that would be highly extraordinary for the average mom-and-pop investor in muni bonds.

Puerto Rico is teetering on the edge of a default of its huge $70 billion muni bond debt, Forbes reported.

Three out of four muni bond mutual funds are estimated to hold Puerto Rican paper, Forbes said.

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