Executive Summary

• Yields are low, but the fundamentals of the asset class remain solid
• Look for positive total returns, but less than what munis delivered in the past two years.

Tax Policy is a Positive

Following the fiscal cliff deal of January 1, investors received a resolution to the question that dominated the muni market during late 2012. whether or not the interest on municipal bonds would be taxed in 2013 and beyond. Municipals in fact dodged the tax bullet despite speculation to the contrary, and they in fact received good news in the form of increased taxes on wealthy investors. The new rules stemming from the fiscal-cliff deal increase the income tax rate from 35% to 39.6% on income above $400,000 for individuals and $450,000 for married couples. Those in the top tax bracket will also face a tax increase on their investment income. Higher taxes, in turn, are expected to fuel increased demand for tax-exempt investments, which is a significant positive for the supply-and-demand equation.

This equation was already favorable prior to the fiscal cliff agreement, as municipal bonds should continue to benefit from the reduced supply of new bonds coming to the market. While 2012 brought a flood of new issues, the fund manager Invesco reports, all of the new issuance was offset by older bonds being called away. The result: a lower amount of supply to satisfy investor demand. Invesco sees negative net issuance (i.e. reduced supply) providing continued support to the market in 2013. This is especially important given that the tax increase is likely to fuel increased demand.

Yields Low, But Still Attractive Versus Treasuries

Yields on municipal bonds fell sharply in the rally of 2012, and absolute yields remain low compared to historical levels as the New Year gets underway. As of November 28, S&P National AMT-Free Municipal Bond Fund (ticker:MUB) offered a 30-day SEC yield of just 1.51%.

Still, municipals remain attractive relative to U.S. Treasuries. Russ Koesterich, the Chief Investment Strategist for BlackRock, wrote on the iShares website in late November: “. not only do munis offer a significant tax advantage, but municipal bonds look cheap relative to other alternatives, particularly US Treasuries. Over the last 30 years, the 10-year Treasury note typically yielded about (0.6 percentage points more than) an index of general obligation (GO) muni bonds of a similar maturity. Today, thanks to the Federal Reserve artificially suppressing yields, the Bond Buyer 11 — an index of GO munis yields – is yielding (1.7 percentage points) over Treasuries… In other words, even before taking into account their tax advantage, municipal bonds are offering superior yields—a critical point for those investors who are looking for additional sources of income. Given the prospects for elevated market volatility and higher tax rates, we have a particularly favorable view toward munis and would recommend investors turn some attention to this area of the market.”

Another fan of municipal bonds is Bill Gross, head of the bond giant PIMCO and manager of PIMCO Total Return Fund, the largest bond fund in the world. According to a Bloomberg report from November 8, 2012, “Gross directed 5 percent of his fund to munis in September. It was the first time he’s held that high a percentage of munis in consecutive months since at least 2006.” Gross noted, “Muni bonds, which are tax-free, would be a valuable type of asset going forward,” if taxes rise in 2013.

A less sanguine view comes from Michael Zezas, Head Municipal Bond Strategist at Morgan Stanley. The margin for error is so thin, he wrote in December. With yields being at the historical lows they’re at, it only takes a small move higher in those yields before you realize negative returns. Citi echoed this sentiment later in the month, saying We expect a more challenging 2013 since the margin of error is much smaller.

Defaults Remain an Issue, so Beware of High-Yield Munis

Another issue that could influence the outlook for municipal bonds in the year ahead is an additional increase in the default rate (or the percentage of issuers that fail to make their interest and principal payments on time). Municipal defaults rose in 2012, highlighted by defaults for three California cities during the summer. While state finances are improving – most notably for California following voters’ approval of temporary tax increases in November’s election – many cities continue to face challenges.

Overall, however, default rates for municipal bonds are very low on a longer-term basis. In a November 2012 article on the market commentary website SeekingAlpha.com, municipal bond expert Glen Rosenberg compared the default rates on BBB-rated municipal bonds to AAA-rated corporate issues. The result: BBB-rated munis paid all of their interest and principal 99.63% of the time, while AAA-rated corporates did so 99.35% of the time. In other words, investors were more likely to see a default from the highest-rated corporate issue than they were a municipal bond of lower quality.

Muni investors should be on alert for a further uptick in defaults, but the strong performance of the market in 2012 amid rising defaults indicated that the issue isn’t a major concern for now. Still, investors in high yield municipal bonds need to be careful. The asset class performed exceptionally well in 2012, returning over 17% in the first 11 months of the year and vastly outpacing the rest of the market by a wide margin. Keep in mind, however, that high yield munis carry more than their share of risks since issuers are typically entities with the weakest finances. Yields remain attractive in this area, but after such large gains there could be significant downside if the municipal market as a whole experiences any disruptions in the year ahead.

Fitch: Be Prepared for Downgrades in 2013

Investors will also need to be on alert for the possibility of rising downgrades in 2013. In its 2013 outlook published in early December, the ratings agency Fitch stated that local governments continue to face financial challenges, and that it expects to downgrade the ratings of “dozens or even hundreds” of issuers in 2013, as reported by the Financial Times on December 3. The main problem is expenses continue to expand faster than revenues, reducing local governments’ flexibility – an issue that is being exacerbated by slow economic growth.

The outlook at the state level was somewhat better. In an interview on CNBC, – Laura Porter, Managing Director at Fitch Ratings – said that “States are fundamentally very strong credits. They have strong control over their revenue and spending, and they have shown the ability and willingness to adjust (to the slowing economy).” Still, lower-rated states such as California and Illinois may face trouble in 2013, particularly if federal spending is cut as a result of the fiscal cliff. Investors should keep a close eye on this issue in the year ahead.

Will Rising Treasury Rates Hit Munis?

The performance of U.S. Treasuries is one of the largest variables for municipal bonds in 2013. While Treasuries are unlikely to collapse right away since the Federal Reserve is artificially holding rates near historic lows, at some point the combination of rising inflation and/or stronger growth will cause the Fed to withdraw its easy-money policies – a shift that is likely to spark a period of negative performance for bonds. While experts are tripping over themselves to proclaim a “bubble” in Treasuries, the end of the bull market will probably take some time to play out – as outlined in my article 2013 Outlook: U.S. Treasuries.

Still, a sudden jump in Treasury yields (and decline in prices would undoubtedly weigh heavily on the performance of municipal bonds. Investors in mutual funds and exchange-traded funds – where this is no option to escape volatility by holding to maturity. as is the case with individual bonds – need to be acutely aware of the potential for loss of principal once the bull market in Treasuries finally ends.

The Bottom Line

There are an unusually high number of variables that could influence the outlook for municipal bonds in 2013, but the vast majority of investors in this area are focused more on fulfilling their long-term investment goals and maximizing after-tax income than on the week-to-week movements of the markets. If anything, market volatility provides this type of investor with the opportunity to put cash to work at higher rates. But keep an eye on the headlines – 2013 is bound to be a very interesting year for municipals.

For now, barring a surprise related to government policy, prepare for total returns slightly above current yields – solid, but less than the returns investors became accustomed to in the past two years.

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. The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.