Morgan Stanley’s main forecast for this year calls for returns ranging from a loss of as much as 3.8 percent to a 0.2 percent gain as an improving economy leads the Federal Reserve to trim its bond-buying program, pushing up interest rates, the bank said in a Jan. 7 report. Photographer: Victor J. Blue/Bloomberg

Jan. 14 (Bloomberg) — The biggest exchange-traded fund tracking the $3.7 trillion municipal-bond market sold this week at the highest premium to the value of its assets since May, an early sign that local debt may avoid a second year of losses.

After the worst year since 2008 for city and state debt, the shift to a premium for muni ETFs points to a potential return to earnings, said Mikhail Foux, a credit analyst at Citigroup Inc. in New York. Local securities may earn 4 percent to 6 percent in 2014, he said.

The $3.1 billion iShares National AMT-Free Muni Bond ETF, known as MUB, sold at 0.28 percent more than the worth of its holdings on Jan. 10, the highest since May, data compiled by Bloomberg show. The premium was 0.1 percent yesterday. The fund is mirroring the broader tax-exempt market as investors are pushing yields down from a three-month high set in December, said Bart Mosley, co-president of Trident Municipal Research in New York.

“Historically, it’s a precursor of abating outflows and stronger performance of munis,” Foux said of the swing to a premium. “We continue to be somewhat bullish on munis.”

Citigroup’s forecast underscores Wall Street banks’ varying outlooks for 2014 in the market, which states and municipalities nationwide use to pay for schools, bridges and roads.

2014 Prospects

Morgan Stanley’s main forecast for this year calls for returns ranging from a loss of as much as 3.8 percent to a 0.2 percent gain as an improving economy leads the Federal Reserve to trim its bond-buying program, pushing up interest rates, the bank said in a Jan. 7 report.

Tax-exempt securities lost 2.9 percent last year, Bank of America Merrill Lynch data show. The last time munis posted two straight annual losses was 1980-1981, according to Barclays Plc data.

The MUB ETF traded at about $105.50 per share in New York, the highest since July, Bloomberg data show. Before last week, the fund had sold either at a discount or at the value of its holdings on all but two days since May, amid losses across fixed-income assets.

Created in 2007, MUB is an exchange-traded fund. ETFs are similar to mutual funds that track indexes of equities, bonds or commodities. Yet they can be bought and sold during the trading day and their prices may rise or fall more than the value of the assets they hold.

Exodus Abates

Demand has revived as munis are rallying this month and as a months-long cash exodus from muni mutual funds is slowing. Benchmark 10-year munis yield 2.73 percent, down from as high as 3.05 percent last month, Bloomberg data show. The rate reached 1.52 percent in December 2012, the lowest since at least January 2009.

“People have been trained to think of interest rates just being too low,” said Mosley at Trident. “And that’s just not true anymore.”

Mosley estimates the MUB will earn in 2014 what the fund’s bonds yield on average, which is about 3 percent, Bloomberg data show.

As individual investors return to munis, they can benefit from potential yield swings resulting from reduced holdings by Wall Street brokers and dealers, said George Friedlander, chief municipal strategist at Citigroup.

Middlemen’s Role

The companies, the municipal market’s middlemen, held $18 billion of munis as of Sept. 30, the least since June 2002, according to Federal Reserve data.

“With a relatively thin and volatile market, there will be entry points for investors,” Friedlander said.

The latest fund data shows individuals, who own about 60 percent of the market either directly or through mutual funds, are growing more bullish.

Investors pulled about $19 million from U.S. muni mutual funds last week, the least since withdrawals began in May, according to Lipper US Fund Flows data.

“There’s still room for some more outflows, but ultimately we’ll get close to stable or zero,” Friedlander said.

To contact the reporter on this story: Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net