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After a robust performance by municipal bonds in 2014 (see chart below ), what should investors watch for in the year ahead? The MacKay Municipal Managers (MMM) team has published its five key insights for 2015 (see their 2014 insights here ). The overall conclusion is that the team sees attractive opportunities in certain segments of the market and believes that positive returns are best achieved through active management.

1. Demand should be strong. Institutional clients such as insurance companies have been adding munis to their core portfolios, and the team expects that to continue. What’s new is that banks’ proprietary trading desks, many of which exited the muni market after the 2008 crisis, may start coming back, lured by favorable market conditions and regulatory developments. And that would also improve liquidity in the market.

2. Supply could be higher than expected, but still tight. The team expects new issuance to exceed $375 billion, surpassing consensus expectations, as the U.S. starts to come to terms with its infrastructure needs. That said, net new supply will remain negative for the fifth year in a row and the overall municipal market will continue to shrink. One reason is refinancing, as issuers take advantage of low yields to replace existing high-coupon debt with lower-cost financing.

3. Yield curve likely to flatten. The team expects a flattening yield curve—i.e. yields on short-maturity bonds rising by more than those on long maturities. So they believe high-grade bonds on the short-to-intermediate part of the yield curve should be avoided in 2015. AA and AAA-rated municipal bonds in the 3 to 7-year maturity range are currently looking expensive, and their high correlations with Treasurys mean they have higher exposure to interest-rate hikes than most other segments of the municipal market.

4. Monolines should continue their comeback. The decline of monoline insurance companies during the 2008 credit crisis caused investors to shun insured munis. But certain monolines are well on the road to recovery, helped by a number of legal settlements allowing them to claw back mortgage-related losses suffered during the crisis period. Strong performance by monoline-wrapped bonds last year, notably during the Puerto Rico debt crisis, has brought them back onto investors’ radar. The team expects insured bonds in the new issue market to exceed 10% for the first time in six years, and says that bonds backed by insurance policies should continue to experience spread-narrowing as outstanding legal settlements are resolved and the value of bond insurance rises.

5. Tobacco should outperform. As municipal borrowers refinance higher-coupon bonds at lower rates, the team expects more investors to look to tobacco settlement bonds to replace income in their portfolios. While the tobacco sector will likely experience periods of higher volatility in 2015, the MMM team believes it will be one of the top performing sectors in 2015.

The year of active management. The team argues that the best way to take advantage of these trends will be through active management, based on careful security selection. Yield-curve strategy is a good example. Passive muni portfolios tend to have a “ladder” structure with equal weights along the maturity spectrum. If investors want to get defensive on rates without sacrificing income, then an active approach is required—in the team’s opinion, emphasizing longer-dated, higher-coupon bonds and de-emphasizing low-coupon, short dated issues. Another example is the tobacco opportunity. While the team expects the sector to perform well overall, research-driven security selection can help identify the most attractive issues at the right price.