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By Timothy Strauts

Municipal bonds had another good year in 2012 as interest rates continued to fall and, despite making a number of high profile headlines, municipal bankruptcies were contained. With interest rates on municipal bonds at 45-year lows, what can investors expect in 2013?

Fiscal Cliff
The "Fiscal Cliff" compromise answered the question as to whether interest on municipal bonds would be taxed in 2013. Municipal bonds avoided all the various proposals to eliminate or reduce their tax exemption. In fact, the increase in the top income tax rate to 39.6% from 35.0% may make tax-free municipals more attractive for some high income investors. After a sell-off in December the municipal market has rallied as investors have shaken off concerns about potential changes to muni bonds' tax treatment in the near term. But the tax status of municipal bonds is far from resolved in Congress.

Credit Quality
Municipalities have been in a difficult situation since the financial crisis. In general, states and municipalities have done more than the Federal government to fix their fiscal issues. They have reduced their workforces, cut budgets, and curtailed spending on infrastructure projects. Despite this progress, various ratings agencies have given negative outlooks for municipalities’ credit quality in 2013. Fitch Ratings expects to downgrade “dozens or hundreds of issuers in 2013.” Fitch believes that local governments will not get to take advantage of recently increasing home prices because property-tax receipts lag tax-base assessments by several years. In many cases property-tax receipts are still declining. Additionally, Fitch notes that contributions to public-sector pension funds will need to be increased to address funding shortfalls, which will further strain public finances. Moody’s expects continued ratings downgrades, but at a reduced pace relative to 2012. Automatic federal spending cuts due to take effect on March 1 will hurt local governments reliant upon federal employment or funding. This could slow local economies and put pressure on municipalities. According to the Congressional Budget Office, this sequestration could cut 0.5% from U.S. gross domestic product in 2013.

A recent report by the Nelson Rockefeller Institute of Government gave some hope that municipal finances are slowly improving. The report noted that state governments have increased tax revenues for 11 consecutive quarters. Local municipalities’ tax collections grew at 2.6% in the fourth quarter of 2012, marking the first increase in three years. At the end of 2012 total tax revenues were above peak levels reached in 2008 in nominal terms.

A good example of improvement is California, which is plagued by well-documented fiscal problems. California’s bonds represent a large portion of most national-municipal-bond funds. For example, in the case of the largest municipal-bond ETF, iShares National AMT-Free Municipal Bond (MUB), Californian bonds comprise 22% of the fund’s portfolio. California passed Proposition 30, which increases taxes for the next four to seven years. The Governor of California proposed a budget surplus for the coming fiscal year, which, if successful, will alleviate the need for California to raise addition funds in the debt markets. Based on the recent improvements Standard and Poor’s raised California’s credit rating to A from A-.

(click to enlarge)
Yield Outlook

The above chart shows the relationship between the yield of the Barclays 10-year municipal-bond index and 10-year U.S. Treasuries. When the spread is negative, a municipal bond yields less than does a Treasury bond. When the spread is positive, the reverse is true. Historically, municipal bonds have yielded less than comparable Treasuries because of their favorable tax treatment. Since the financial crisis this relationship has changed. This shift can be primarily attributed to the market’s concerns over the potential for a spike in defaults among municipalities.

Since early 2009, the yield spread has contracted substantially. Today, the average 10-year municipal bond yields about 2.0%, which is close to parity with the 10-year Treasury. Given the current credit outlook, it seems unlikely that municipal bonds will return to their negative spread relationship in the next few years. If that is the case then there is little room for yields to drop further unless Treasury yields fall.

The two largest municipal bond ETFs, MUB and SPDR Nuveen Barclays Municipal Bond (TFI), have current SEC yields of 1.6% and 1.7%, respectively. Based on these current yields and moderate tightening in the yield spread versus Treasuries, the best-case scenario for investors is returns of only 1% to 4%. Of course, if you are in a high tax bracket these tax-free returns may still be attractive.

On the other hand, there is very little margin for error in the municipal market. Yields have very little room to head lower. The Treasury yield was recently at 2.0% and has already risen from a low of 1.4% touched in July 2012. The Congressional Budget Office projects the 10-year Treasury yield will be at 3.0% in 2015 and at 3.8% in 2016. If yields rise as projected, municipal-bond funds will have difficulty producing positive returns in the years ahead.

Potential Tax Changes
The Federal government needs to cut a large amount of spending and/or find additional sources of revenue in order to address the nation’s deficit. The Joint Committee on Taxation estimates that taxing interest payments from municipal bonds at federal income tax rates would generate $200 billion in additional revenue per year. Of the 10 largest potential sources of new revenue highlighted by the committee it was one of the only ones that predominantly affected wealthy Americans. In the current political environment, many believe it would be more politically palatable to introduce tax changes that would have minimal effect on lower- and middle-income taxpayers. Given this backdrop there are multiple proposals that are being considered as it pertains to municipal bonds’ tax treatment.

The first and most unlikely is to eliminate the tax exemption completely. This would raise the most revenue but have very negative knock-on effects for municipal issuers. Considering the currently weak credit profile of many municipalities, the market would demand dramatically higher interest rates to make new debt issues appealing. This option was put forth as part of the Bowles-Simpson plan and Paul Ryan’s 2012 Budget proposal. The proposal would only affect new issuance, so interest payments from existing bonds would receive favorable tax treatment. If this proposal went into effect legacy bonds could rise in price as investors tried to acquire the remaining existing issues that would continue to receive favorable tax treatment.

The second option on the table would involve subsidizing issuers and removing the tax benefits of municipal bonds. The Build America Bond program is an example of this type of arrangement. The BAB program was quite successful with $181 billion in bonds issued over the life of the program. BAB issuers received a federal payment amounting to 35% of the interest costs as compensation for the higher interest rates the issuers had to pay on the taxable bonds. The Congressional Budget Office has proposed reducing this subsidy to 15% to allow the Federal government to collect more in new taxes than the subsidy would pay out. President Obama’s 2012 budget proposed reinstating the Build America Bond program.

The third option being considered is to expand the base of potential municipal-bond buyers by offering tax credits to the investors that purchase them. The Wyden-Coats bill seeks to spread the benefits of owning municipal bonds equally to all taxpayers, regardless of their income. Interest payments from municipal bonds would no longer be tax-exempt, but bondholders would receive a tax credit equal to 25% of the interest earned.

The fourth option being mulled would involve limiting the tax rate that high income individuals can reduce their tax liability to 28%. This limit would apply to all itemized deductions, foreign excluded income, tax-exempt interest, retirement contributions, and employer health insurance. This proposal was part of President Obama’s 2012 budget and is expected to be included in his 2013 budget. The provision would affect individuals earning $200,000 a year or more and married couples filing jointly with incomes in excess of $250,000. Unlike the previous proposals which would affect only newly issued bonds, this option would affect both new issues and existing municipal bonds.

Finally, the Federal government could simply leave the municipal market alone. Until the Federal government gets its spending in order, the threat of tax law changes hangs over the municipal market. Because of the factors I have discussed above I would expect volatility in the sector to remain elevated over the next year, as investors react to the changing political and economic environment.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Muni-Bond Outlook: Expecting High Relative Volatility Due To Low Yields, Potential Tax Changes