By Lisa Lambert
WASHINGTON (Reuters) - Rising interest rates shook up the U.S. municipal bond market in the middle of the year, bringing a long run of refinancing to a halt and tempering new debt sales, Federal Reserve data showed on Wednesday.
The amount of outstanding municipal debt shrank in the second quarter to $3.721 trillion from $3.729 trillion in the first quarter and from $3.732 trillion a year earlier, the Fed said.
In May, the Fed signaled that it could soon begin to reduce monetary stimulus. The news roiled fixed-income markets as investors sold bonds and shifted funds to stocks in a "great rotation" that lifted interest rates.
Detroit's financial distress made the quarter even more volatile for municipal bonds as investors grew skittish ahead of the city's filing in July for the largest U.S. municipal bankruptcy ever.
"We anticipate net negative issuance, meaning more bonds will come out of the market in 2013 than will come into the market," said Blackrock Municipal Bond Strategist Sean Carney.
BlackRock has slashed its forecast for issuance in 2013 to $345 billion from $388 billion and it expects 2014 to remain weak, Carney said. The decline will be led by refundings, as higher interest rates make refinancing unattractive, he added.
Over the second quarter, yields on top-rated debt shot up along Municipal Market Data's benchmark scale. Yields on highly rated 30-year bonds rose 74 basis points to end the quarter at 3.83 percent. Rates of top-shelf 10-years jumped 67 basis points to end the quarter at 2.56 percent.
The rates remain higher. On Wednesday, yields on highly rated 30-years were 4.11 percent and those on top-shelf 10-years were 2.54 percent, according to MMD, a Thomson Reuters company.
Florida cannot alter planned new debt sales linked to capital projects already approved or underway, said Ben Watkins, head of the state's division of bond finance. But the interest rate environment has ended advanced refundings of Florida bonds.
"Basically we've done the refundings that are economically feasible for us to do," he said, noting the last refunding deal was in May. "We didn't have to scrub any, but we had others that would be candidates coming up but are no longer in the money."
A couple of years ago, issuers rushed to refinance as interest rates scraped record lows.
"We've been at historical lows and things don't stay at historic lows forever," Watkins said. "People are dumping their fixed-income investments in favor of riskier asset classes like equities. We're not immune to that."
According to Thomson Reuters data, refunding deals hit $71.31 billion in 2,067 issues in the second quarter of 2012, representing nearly two-thirds of the issuance that quarter. They plummeted more than 25 percent to $50.74 billion in the second quarter of this year, spread across just 1,685 deals.
New and refunding deals altogether totaled $88.62 billion in the second quarter, compared to $113.35 billion in the same quarter in 2012.
MOMS, POPS, BROKERS, DEALERS LOSING APPETITE
Retail investors, the "mom and pop" buyers who support the municipal bond market, have been shaken by shifting interest rates. In the second quarter, their market share shrank to 44.3 percent from 47.5 percent the year before, the Fed data shows. The household sector shed $32.2 billion of municipal bonds after acquiring $2.3 billion the quarter before.
In the second quarter, broker-dealers, a much smaller share of the market, shed $48.1 billion worth of municipal bonds. That was the largest amount since the credit freeze of 2008, when they dropped $92.82 billion in the fourth quarter, according to the Federal Reserve's seasonally adjusted data.
Broker-dealers are committing "half the balance sheet they did just in 2010," to municipal bonds, said Carney.
"In the second quarter there were likely large losses within the sector," he said, adding that broker-dealers could be "doing more with less," by turning over more bonds and holding fewer.
Issuance totals for the month of September are not yet available. But, as of September 25, new debt sales for the month totaled $8.48 billion in 364 issues and refundings $5.1 billion in 169 issues.
Starting in May, the average monthly drop in issuance from the year before has been around 24 percent, said MMD Analyst Domenic Vonella. He expects monthly issuance decreases of 18 to 24 percent to continue through the end of the year.
Issuance of tax-exempt debt will likely total $250 billion the year, he said, a drop of more than 20 percent from the $327.72 billion of tax-exempt bonds sold in 2012, but close to the issuance of 2011.
(Reporting by Lisa Lambert; Editing by Chizu Nomiyama and David Gregorio)