They were never that bad to begin with, says Mackay’s Bob DiMella

Municipal bonds will be one of the best performing fixed-income asset classes this year.

After high-profile predications of disaster in the space, its a statement not heard for some time, but one Bob DiMella (left) confidently makes.

The senior managing director and portfolio manager at MacKay Municipal Managers, a part of New York Life, says the $3.7 trillion municipal-bond market was never as bad as people said.

The people making those predictions never really had a grasp of municipal financials, DiMella explains. They didnt understand the steps state and local governments could take to fix their situations. Were telling clients were not there yet and some fear is still being priced in, but its no longer a panic.

For this reason, he sees 2013 as a comeback year and is calling it The Year of Income.

There will be more upgrades than downgrades this year, which is significant, he adds.

MacKay and Dimella identified five key themes for muni bonds in 2013, including:

1. Credit cycle has troughedfundamentals begin uptrend

After recent years of more ratings agency downgrades versus upgrades, we expect the trend in the municipal market to stabilize.

2. Municipal to Treasury yield ratio reverts back toward 2008 pre-crisis historical averages

Were not there yet, but once the risk premium is taken out we will be. We would recommend investors reduce exposure to securities that possess heightened sensitivity to rates, and hold onto securities that offer incremental yield, especially due to spread duration.

3. Remain long spread duration, but shift to defensive interest rate postureincome will drive return

This one is a little different for us this year. Despite the low interest rate environment, muni bonds never really experienced them. As a result, we told clients not to worry about interest rate risk duration in the muni space. But now, after three years, were seeing interest rate duration getting pricier, and were paying attention to those assets that have sensitivity to pricier areas of the market. Historical averages could be the norm in 2013 based on several factors including: (1) improving municipal fundamentals, (2) increased demand for tax-exempt bonds as a result of higher tax rates, and (3) U.S. Treasury yields losing their flight-to-quality bid. We believe this will allow municipal bonds to perform well on a relative basis.

4. Advance refunding will accelerate in 2013

This is a unique phenomenon to the muni market. Municipalities can only refince once because of IRS rules, so when they do, they want the most bang for their buck. We believe that the environment is heading to an advance refunding cycle in A/AA-rated municipal bonds. Issuers with high coupon debt issued in vintage years 2008 and 2009 will likely capitalize on this one-time opportunity to lower costs by issuing new debt at a favorable rate and advance refunding their older, more expensive debt.

5. Health care and airport sectors outperform

Following up on our insight that the credit cycle has troughed, we feel that the health care and airport sectors are poised to outperform in 2013. For airports in particular, more people flew in 2012 than ever before, and we expect that to continue in 2013. Also, airlines are poised to start making money again.