Expectation for Muni Bonds in 2014

This past year was a tough one for municipal bond investors with the Barclay’s Muni Bond Index posting its worst performance in the past 20 years.  This negative performance was driven in part by the high profile bankruptcy of Detroit and the issues related to cash strapped Puerto Rico.  Municipal bonds were also negatively impacted by rising interest rates driven by the Fed’s announcement in May that they would start tapering their monthly bond purchases. 

As we begin 2014 it is important to evaluate the market conditions for muni bonds and the role they play in a portfolio.   The general assessment of the muni market is that 2014 could see continued volatility but things should be better than 2013.

 

From a credit perspective, there could be some specific credit issues with certain municipalities but with the economy continuing to improve and the financial health of local and state governments improving, the issues won’t be wide spread.  Even in 2013, the decline in bond prices was driven more by investor fear and panic versus real credit issues across the full muni bond market.  

 

In 2014, one of the areas that will help provide a level of support to bond prices is the limited supply of bonds available to investors.   Next year will likely continue the trend of recent years of low muni bond issuance as shown in Exhibit 1, because governments will be continuing to work on improving their balance sheets and limiting the amount of outstanding debt that they are issuing. 

 

Exhibit 1

With the Fed beginning to taper their bond purchases in January we will probably continue to see interest rates increase.  If this is the case, there could be temporary downward pressure on bond prices.  The important thing to remember is that over the long-term, higher rates are a good thing for bond investors because it will eventually translate into higher income for those investors.

 

The other item that will help support muni bond prices next year is the increase in demand from  high income earners who will want to limit the impact of a higher marginal tax bracket of 39.6% and the new Medicare Investment Tax of 3.8%.   Both of these higher tax rates went into effect in 2013.

 

As to what action an investor should take with their muni bond investment there is no easy answer as it depends on many factors.  A few of those factors include the investment time horizon, maturity and credit risk of the bonds and the overall allocation to the asset class in the portfolio.  And as is the case for any asset class, it is always beneficial to examine the role a particular investment will play in a portfolio.  For an investor who is looking for an asset class that provides tax-free income, diversification from equities and safety in a crisis situation, then muni bonds could have a role in their portfolio even after a difficult year like 2013.