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Municipal Bonds Show Strength as Recovery Continues

Despite Puerto Rico’s travails and scattered pension issues in the U.S., state and local governments are thriving. And so are munis.

Although Puerto Rico’s default dominates news about the U.S. municipal bond market, the overall picture is quite bright, as most other public entities are doing just fine, thank you, analysts say.

Puerto Rico, a U.S. territory, shares little in common with other municipalities. “There are 60,000 municipal issuers, and only a dozen or two are having problems,” says Joseph Rosenblum, director of municipal credit research for AllianceBernstein in New York. “Most municipalities are doing what they are supposed to do: paying their obligations and continuing to move forward.”

In fact, the Barclays Municipal Bond index returned 3.08 percent year-to-date through May 17, and 6.52 percent for the 12 months through May 17. The Barclays U.S. Treasury index returned 3.41 percent and 3.6 percent during those periods. And analysts say munis’ strength is likely to continue.

As for Puerto Rico, it began defaulting on a portion of its $70 billion debt earlier this year, and concern is growing that it won’t be able to make $2 billion in principal and interest payments due July 1. As distressing as that is, Puerto Rico’s problems have been known for some time. “You could see it ten years ago,” says Timothy McGregor, director of municipal fixed income at Northern Trust in Chicago.

Because of its status as a territory of the U.S., it’s overseen by the U.S. Congress. “It’s simply its own creature,” says Phil Fischer, head of municipal research and global indexes for Bank of America Merrill Lynch in New York. “It tried to lever its way out of recession, and now Congress is trying to figure out what to do.” Republican and Democratic leaders in the House of Representatives agreed on legislation Wednesday that would create a control board to help manage Puerto Rico’s debt and oversee its restructuring.

Meanwhile, states and cities are working their way out of budget problems that developed during the Great Recession, which began in December 2007 and ended in June 2009. State tax revenue climbed 6 percent last year, according to Moody’s Investors Service. Total net tax-supported debt for states was virtually unchanged last year at $512.5 billion, down from its 2013 peak of $516 billion, Moody’s estimates. Energy-producing states face budget problems in the wake of oil’s steep price drop. “But I think they will get through them,” Fischer says

A bigger threat for states and cities is ballooning pension and health care payments for retirees. But state and local governments are working to reduce their obligations. And with the notable exception of Illinois, courts have generally approved revisions, allowing states and cities to reduce pensions for future retirees but not for those already retired.

“The vast majority of bonds are in very good shape,” Fischer says. “Ratings on states are all very high.” Moody’s and Standard & Poor’s rate every state but Illinois and New Jersey at least double-A.

So it’s no surprise that demand has been strong for munis. Open-end muni mutual funds and exchange-traded funds saw an inflow of $22 billion in the first four months of the year, a record high for the period, according to Morningstar. The Barclays Muni index yielded 1.75 percent May 17, and that’s before the tax exemption generally available for individual U.S. investors.

Meanwhile, new customers are snapping up munis. “A significant amount of traditional buyers, probably 20 to 25 percent, has been replaced by hedge funds,” AllianceBernstein’s Rosenblum says. Traditional buyers are mutual funds and retail investors. Insurance companies, banks, taxable bond funds and international investors are diving into munis too.

Low interest rates around the world are pushing these players toward munis, analysts say. “There’s a continuing search for yield,” says Peter Hayes, head of municipal bonds for BlackRock in New York. “Munis may look rich on an absolute basis but are attractive on a relative basis.” The Barclays Muni index yield of 1.75 percent almost matches the ten-year Treasury yield of 1.76 percent. “Municipal bonds are subsovereigns, as far as foreign investors are concerned,” Fischer says. “They’re a good vehicle for diversification.” Foreign interest in munis will likely spread from taxable issues to tax-exempt as well, he says.

When it comes to specific credits, Rosenblum likes a number of munis from California. The state’s school districts benefit from voter approval of a property tax to support their debt, he says. And the state’s economic growth has been strong, though there are signs of a slowdown. Most local governments are highly rated. AllianceBernstein also hold bonds of some publicly owned utilities around the country, including some in California.

Given the muni market’s strong fundamentals, it has further room to rise, most analysts agree. “The market is in the mood for as much supply as state and local governments want to issue,” Northern Trust’s McGregor says.

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