Higher rates double trouble for US muni investors

March 4, 2011

By Agnes T. Crane
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

NEW YORK — Rising interest rates are bad for bond investors generally. But in the $3 trillion municipal debt market where U.S. states, cities and other public entities raise funds, hysteria over possible defaults already has investors rattled. When rates rise and more paper losses accumulate, some may simply give up.

For evidence, look back to November. Treasury yields spiked, somewhat ironically, after the Federal Reserve unveiled its second, $600 billion bond-buying program aimed at lowering rates. The move helped ignite big losses in municipal bond mutual funds. Interest rate risk is similar for all bond investors, but muni holders had been, and still are, suffering from agitated talk of defaults. The result was a run for cover. One closely-watched and usually staid muni exchange-traded fund fell nearly 5 percent over a few days — a massive move — as the 30-year Treasury yield drove half a percentage point higher. The ETF still hasn’t recovered.

Fast forward again, and sharply higher rates are almost inevitable before too long. Policy interest rates of zero to 0.25 percent can only eventually go up. The Fed’s bond-buying efforts will end by June. Pimco’s Bill Gross reckons a 4 percent yield on the 10-year Treasury — half a percentage point higher than currently — wouldn’t be unreasonable after the U.S. central bank gets out of the market. And a recovering economy and flickering inflation will tend to push yields higher, and bond prices down.

As of now, the muni bond market has stabilized somewhat after hitting a low point in mid-January. Issuers’ reluctance to test the market coupled with relatively stable interest rates since then have lent steadying hands. A somewhat tempered view of default risk has also helped. Roubini Global Economics estimates $100 billion of defaults could be coming, but over five years and with high recovery rates for bondholders. Earlier scaremongering comments from analyst Meredith Whitney suggested multiples of that volume of defaults, and over a much shorter period.

But the muni bond market is heavily dependent on retail investors. It’s unrealistic to expect that they’ll simply hunker down when interest rates begin their next leg higher. Even institutional investors could hold out for much cheaper valuations before they’re willing to take on both interest rate and credit risk with new money. Throw in the headline-grabbing state and local budget battles still to come, and the muni market faces a testing year.

Comments

Wasn’t the intention of QE2 to *raise* long-term rates by increasing growth expectations and reassuring investors that deflation would not be permitted?

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