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By Guy Davidson

Federal Reserve Chairman Bernanke reiterated today (Wednesday) that a healthier economy would prompt the Fed to end its unprecedented bond-buying program, which has kept yields artificially low. Speculation on this question over the last several weeks has caused a sharp bond sell-off and rising yields. But we don't see this as the start of a rout for most municipal bonds.

The timing and pace for closing out quantitative easing will depend on the rate of U.S. economic growth- an unknown. That's why there's so much uncertainty in the bond market today. Our forecast is for the Fed to begin tapering its purchases off in September. But to understand what might happen when rates rise back to a more normal level, we think it's helpful to look at what has already taken place. The sell-off that everyone's worried about actually began last summer.

Roughly 11 months ago, at the end of July 2012, the 10-year Treasury yield was 1.5%. Today it's 2.3%, an increase of 80 basis points. How did municipal bond portfolios react to this jump in yields? They actually provided modestly positive returns. Investment-grade portfolios returns averaged 0.2%, while high-yield portfolios returns averaged 2.6%. Those are far from the sharply negative returns most investors worry about.

But what if yields go up another 70 basis points, with the 10-year Treasury yield hitting 3.0% over the next year? Based on the experience of the last 11 months, we believe investment-grade municipal bond portfolios could return between 0.5% and 1.0%, and high-yield portfolios could return between 3% and 4%. Those are modest returns, but they're positive returns in a rising-rate environment and higher returns than over the last 11 months- primarily because the starting yields are higher.

We'd also expect investment grade and high-yield portfolios to outperform municipal money market portfolios. The Fed has pledged to keep the Fed Funds Rate near zero until the unemployment rate drops to 6.5%, which isn't expected to happen over the next year.

What if the economy continues to expand modestly and interest rates are largely unchanged? Expected returns could end up better, ranging from 2% for intermediate portfolios to 5% for high-yield portfolios.

So, the average municipal bond should fare reasonably well, but does that mean all municipal bonds should be OK? Like a man with his head in the ice box and his feet in the oven, we can't expect the average to describe all points along the range. Long maturity bonds, especially those with prices near $100 today, could lose between 4% and 6%.

Likewise, leveraged municipal portfolios, like closed-end funds, could also experience significant losses. In short, we recommend reducing the interest-rate risk of municipal portfolios and focusing on holding intermediate maturity and high-yield bonds, which should continue to provide the relative stability investors are looking for over the next year- even as yields rise to more normal levels.

Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.

Guy Davidson is Director of Municipal Investments at AllianceBernstein.

Source: Municipal Bonds: A Glimpse Of What's To Come?