New Year, New (and Old) Reasons to Like Munis

Despite policy uncertainty and volatility in broader financial markets, municipal bonds managed to keep calm and carry on in 2012, emerging as a fixed income standout with a total return of roughly 7%. Munis' solid showing was not lost on investors, who continued to funnel assets to the market. Can the asset class keep on keeping on in 2013?

BlackRock's Managing Director of Municipal Bonds Group, Peter Hayes says "yes," but advises that investors may need to refocus—and reset their expectations for the asset class.

"...Munis have really exceeded expectations over the past couple of years, and I think the more appropriate question at this juncture might be, "what shouldn't investors expect?" That's not to say the market doesn't have a lot to offer, but investors should be clear that the robust positive returns we saw in 2011 and 2012 are not likely to three-peat. Even with the Fed committed to keeping rates low into 2015, and barring another crisis, muni rates really don't have room to move much lower. That means limited scope for price increases. I would also say investors should not expect stable or one-way price action in 2013. While munis do tend to react to market events with much less drama than taxable bonds or equities, we expect markets to be more volatile overall. Ultimately, we suggest investors focus on municipal bonds for income rather than capital appreciation. This is the market's hallmark and what investors have always appreciated about munis. We believe proper security and sector selection can translate into attractive relative income in an environment where it is very hard to come by..."

"...Taxes were a big source of uncertainty throughout 2012. The January 1 fiscal cliff deal offered clarity on a few, but certainly not all, points. For munis, one of the only tax-advantaged asset classes, the outcome was largely positive. First and foremost, the higher marginal tax rates for high-income earners are clearly favorable for munis, enhancing the value of tax exemption. Secondly, to the extent that other asset classes are negatively affected by tax law changes (e.g., higher dividend and capital gains taxes for those same earners), that too is a relative positive for munis. Likewise, the limitation of itemized deductions for individuals with annual income over $250,000 ($300,000 for couples) also makes munis' tax-exempt nature a draw, allowing investors to keep more of what they earn..."

"...The one pitfall for the asset class is the potential for a change in the treatment of tax exemption. To be clear, we don't think there's any danger of tax exemption being eliminated altogether, but there have been proposals to cap it. We think such a move would be highly unpopular among market participants and politicians and difficult for policymakers to pass. And, as revealed in the fiscal cliff negotiations, compromise in a divided government is very difficult. Any additional conversations around tax reform promise to be just as strained, and that could mean it would be very complicated for certain items (such as tax exemption) to get carved out on the negotiating table. As such, we expect little change. Even if munis were to become entangled in broader tax-reform conversations, we would foresee limited market impact given the offset of higher marginal tax rates and the other points I outlined above..."

"...Munis are paying more income than Treasuries before tax. The upshot is that munis look exceptionally good relative to Treasuries, and we simply see no impetus that is going to push Treasury rates dramatically higher and change this relationship in the near term. Beyond that, munis also look very good relative to corporate bonds, and even better when you factor in the recently approved higher tax rates (highest margin tax rate of 39.6%, plus the 3.8% Medicare tax)..."

Source:  BlackRock

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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