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Faced with a looming fiscal cliff and low Treasury yields, investors are showing a renewed interest in municipal bonds. In the past month and half, we’ve seen investors take a particular interest in muni ETFs including the iShares S&P National AMT-Free Municipal Bond Fund (NYSEARCA:MUB) and the iShares S&P Short Term National AMT-Free Municipal Bond Fund (NYSEARCA:SUB).

Why? Right now, munis are attracting interest from investors for a number of reasons.

First off, investors who are searching for income are turning to muni bonds because they offer a more attractive yield than Treasuries. Historically, munis have yielded less than US Treasuries as their income is exempt from federal taxes. The ratio of AAA municipal bond to US Treasury yields has averaged about 93% over the past 10 years, according to Bloomberg. But in times of concerns over muni credit quality this ratio has increased to over 100%. Although a few city and local municipalities having declared bankruptcy this year, today the overall health of municipal issuers is relatively strong. Despite this, muni yields are still over 100% of the yields on US Treasuries – on a historical basis, investors are being paid a relatively attractive rate to take on muni credit risk.

Another benefit of munis is their current tax-exempt status. With the impending fiscal cliff, some investors are concerned that tax rates might rise. In such an environment the tax-exempt income provided by muni bonds would be even more beneficial relative to taxable investments. It appears that right now investors are weighing this benefit against conversations that have been taking place in Washington around potentially removing municipal bonds’ tax-exempt status. While changing the tax policy that applies to munis has been discussed in the past, each time it has induced major pushback from municipal investors and issuers. For instance, this topic came up last year (and I wrote a blog about it) when President Obama unveiled a $450 billion job creation plan that included a proposal to cap the tax breaks for certain municipal-bond holders.

It appears that right now investors believe munis will maintain their tax-exempt status. In fact, if higher taxes are imposed in 2013, then munis could look more attractive. Unless Congress acts, the top marginal rate will increase by 4.6% and the Affordable Healthcare Act will add 3.8% to investment income. So a 4% muni yield would compare to a 7.1% yield on a taxable investment assuming a new marginal tax rate of 43.4%. Investors have taken notice of these attractive valuations and have added $48.1 billion into muni mutual funds and ETFs this year.

(click to enlarge)Supply and demand technicals are also making municipal bonds attractive going forward. While investors have been demanding more munis, as evidenced by the above chart, municipalities are issuing less debt. The BlackRock Investment Institute estimates a decline of the amount outstanding in the muni bond market by $25 billion annually in the next 3 years. With fewer new infrastructure projects and a decrease in local spending, there is less need for municipalities to issue more bonds. Such a scenario would result in less supply, which would pressure prices higher and yields lower.

What does it all mean? Given today’s attractive valuations, tax benefits, and the outlook for supply and demand, we currently favor munis relative to other sectors of the bond market. While the fiscal cliff is a cause of uncertainty, there may be a silver lining in municipal bonds.

Source: Bloomberg, BlackRock and the Investment Company Institute

Disclaimer: Bonds and bond funds will decrease in value as interest rates rise. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.

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Source: As the Fiscal Cliff Looms, Investors Favor Munis