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Municipal bonds expected to make a comeback

The dynamics are improving for municipal bonds, which were beaten down so badly last year that they posted their worst returns in nearly two decades.

The 3.5 percent return for high-grade muni bonds so far this year has been a welcome turnaround from 2013’s disappointing 2.6 percent decline.

“I am optimistic about the returns on municipal bonds for 2014,” said Jay Sommariva, vice president and senior fixed income portfolio manager for Fort Pitt Capital Group in the Pittsburgh area.

He is bullish partly because last month’s issuance of $14 billion in muni bonds was the lowest amount in a February for the past 10 years. The lack of supply is causing investors to scramble for available bonds, which increases returns. Also, with Treasury bond yields going down, investors tend to look for higher yield in other places, such as municipal bonds.

The municipal bond market, in which governments raise money for public projects by borrowing from the public and repaying the money with tax-free interest, has historically been a sound investment. State and local governments with the highest credit ratings – AAA ratings – can usually be relied on to make their payments to investors on time.

But many investors fled the market in a massive sell-off in May and June last year when rates for U.S. Treasury bonds jumped. Muni bond investors also were spooked by high-profile troubles with bonds issued by Harrisburg, Pa., and Detroit, as well as problems with bonds in Chicago, California and Puerto Rico.

Detroit, which filed the largest municipal bankruptcy in U.S. history, was a sobering reminder that general obligation bonds issued by even the largest cities could be unsafe bets.

Detroit was forced to restructure its debt to make the repayment terms for the city more favorable. Harrisburg was able to distribute the cost of a financially troublesome incinerator project to some private investors, which alleviated the burden on the state.

According to Moody’s rating agency, there has never been a AAA-rated municipal security default. Among AA-rated municipalities, only 1 in 10,000 have defaulted. The comparable default rate for AA-rated corporate bonds, however, is 1 in 111 bonds.

Detroit’s bonds were generally rated Baa3 through Baa1. Harrisburg’s bonds were at one time rated AA3, a relatively high credit rating. Many investors were taken by surprise when the city defaulted on its debt, Sommariva said.

Tom Kozlik, director and municipal credit analyst for Janney Capital Markets in Philadelphia, said that since 1980, there have been about eight municipal bankruptcy filings per year. Most recently, in 2013, there were seven. So far in 2014, there has been one municipal bankruptcy: Ozark Mountain Solid Waste District in Arkansas, with $12 million in debt outstanding.

He said Janney continues to favor the municipal bond asset class but the still “not healthy” U.S. economy is a major factor to consider when investing.

There are quality bonds available, he said, but individual selection is more important than ever before. He said some muni bond issuers are not adjusting as they should to reduced tax revenue and that may cause problems going forward.