NEW YORK — Conditions were nearly perfect for municipal bonds last year, leading to sizable returns. Perfection never lasts, though, and managers of municipal-bond funds are forecasting modest returns in upcoming years.
The backdrop for municipal bonds last year was as pleasant as a warm spring breeze: Interest rates were falling, the economy was strengthening, demand was high for bonds that pay tax-free income and supply was relatively low. Add it up, and the Barclays Municipal Bond index returned 9.1 percent in 2014. Just don’t expect a repeat.
“Definitely manage those expectations,” says Diederik Olijslager, who co-manages the $3.9 billion USAA Tax Exempt Intermediate-Term fund, among other municipal-bond offerings. “It’s fixed-income investing, it shouldn’t be 10 percent returns a year.”
Gains are still likely in coming years, but managers say they’re likely to be closer to 2 percent or 3 percent, depending on the type of bond. Another cloud in the forecast: Managers also expect volatility to pick up following a very calm 2014.
Investors have had a sneak peek: The Barclays Municipal Bond index fell in February, its first monthly loss since 2013, snapping what had been its longest winning streak in more than two decades. Among the factors affecting the municipal-bond market:
Municipal bonds are producing less income than a year ago because their yields key off Treasury rates, and the yield on the 10-year Treasury note is below 2 percent. It was around 2.70 percent a year ago and close to 4 percent five years ago.
Rates are so low, the worry is that they will rise and knock down the price of existing bonds. And the improved job market means most economists expect the Federal Reserve to raise short-term rates this year.
Conventional wisdom says investors worried about rising rates should focus on short-term bonds.
That’s because long-term bonds lock in yields for longer periods of time, which makes their prices more sensitive to rate changes.
But even after the Fed hikes rates, long-term rates could continue to stay low given how weak inflation is. That’s one reason Josh Gonze, a portfolio manager at Thornburg Investment Management, is staying neutral on interest rates and refraining from leaning on just short-term bonds.
Gonze says he’s not willing to bet on where long-term rates will go relative to short-term rates: “I know that I don’t know, and I know that no one else knows either.”
States, cities and other local governments are issuing bonds at a faster pace this year, and when the supply of anything increases, that can push prices lower.
