INSIGHTS

On January 11, 2013

Crosscurrents and Contradictions: Which Way Will Municipal Bonds Go?

Here are two possible 2013 scenarios for municipal bonds:

Scenario 1: Higher tax rates continue to fuel the strong demand for municipal bonds. The exemption on municipal bond interest is left alone. The supply of new issue municipal bonds is somewhat higher than in 2012 but not enough to cause indigestion in the market. The economy and the labor market continue their gradual recovery with no growth surprises to the upside. The Federal Reserve (Fed) shows no sign of modifying its accommodative stance. Any rise in U.S. Treasury bond yields is fairly muted.

Scenario 2: The exemption on municipal bond interest is modified or eliminated, municipal bond values adjust negatively, and the demand for municipal bonds falls off sharply. The supply of new issue municipal bonds is meaningfully higher than in 2012, partially due to a large number of deals brought to market to beat the effective date of tax code changes. The housing sector, the labor market, and the economy generally exhibit growth above expectations. Investors shift from bonds to a healthy stock market. Headline risk from the Eurozone diminishes; there are even beginning signs of an economic turnaround. There is increased talk among market participants (and dissension within the Fed) that the Fed’s extended timeline of monetary accommodation will not hold. The rise in U.S. Treasury bond yields is sizable.

The two possible scenarios outlined above are quite different with very different outcomes for municipal bonds, and that is what makes any 2013 municipal bond outlooks difficult to offer with certainty. Scenario 1 will likely have a relatively benign impact on municipal bond values while the impact of Scenario 2 will be more negative. Of course, the possibilities municipal bond investors will face this year include more than just the two stark contrasts presented above. Any combination of forces listed in Scenarios 1 and 2 may come true and in varying degrees. Add in a steady stream of political noise and unknowable, random flights to quality and you have a recipe for a variety of crosscurrents producing possibly contradictory outcomes.

Here are some takeaways we offer for the municipal bond market in 2013:

• Talk and speculation about changes to the municipal bond exemption will persist. Determining the actual probability of tax code changes and what final legislation would look like, however, involves assessing the political process, an area that is notoriously difficult to predict. We suggest it is unwise to dramatically alter investment allocations based upon speculation of what may or may not happen to the tax code.

• We believe the probability of changing the municipal bond exemption as part of a broad tax reform agreement is now lower than previously thought (see Political Small Ball and Its Impact on Municipal Bonds). There still remains the possibility that the municipal bond exemption alone could be singled out for change as the tug-of-war begins between spending cuts and revenue raising in the form of limiting or eliminating exemptions/deductions.

• If changes occur to the municipal bond exemption, existing bonds will either be grandfathered or not. If grandfathered, municipal bond values on existing bonds will likely not be negatively affected in a major way and may even see a positive valuation impact. If there are no grandfather provisions and all municipal bonds are affected, we estimate the impact on the short/intermediate part of the municipal yield curve will be more muted (an estimated 2% to 8%) than in longer maturities.

• If a change comes to the municipal bond exemption, it is likely that the market’s initial reaction and shift in municipal bond values could be larger than previous tax-exempt/taxable yield relationships would suggest is appropriate. That overreaction could present a buying opportunity.

• Even with possible tax changes to municipal bonds, we believe a few broad truths will continue to hold: our nation’s infrastructure needs will remain large, municipal entities will need to finance long-term projects for the benefit of their communities, and the asset class called municipal bonds (tax-exempt or taxable) will continue to exhibit characteristics desired by investors. These characteristics include an enviable record of safety and resiliency, comparatively modest volatility, tremendous variety to help investors with diversification, and attractive yields among conservative investment choices.

• The housing market, the economy generally, and state and local tax collections in most areas of the country will continue to improve in 2013. Given the tremendous size and diversity of the municipal bond market and the constant budget pressures that will remain for most issuers, however, diligence in assessing credit quality of municipal bonds will be as critical as ever.

Whether municipal bond investors ultimately lean more toward believing Scenario 1 or Scenario 2 will depend on a number of factors including individual risk tolerances. With municipal bond yields just off historical lows and the potential negative impacts from Scenario 2, a bit of caution toward municipal bonds is understandable. In a world of essentially zero percent return on cash and very slim U.S. Treasury bond yields, however, we do believe that caution can be honored, meaningful yields garnered, and potential volatility weathered reasonably well in the short/intermediate space of the municipal bond universe.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at ~/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com