In 2012, the municipal bond market continued to provide attractive returns, up 6.78% for the year.
Market technicals have supported the market, and net new supply is not expected to increase dramatically in 2013.
This year’s higher tax rates further enhance the attractiveness of tax-exempt income.
In 2012, the municipal bond market continued to provide attractive returns, increasing 0.67% in Q4 and 6.78% for the year. This was the eighth consecutive quarter of positive returns.† Significant gains through November were partially given back in December, as individual investors retreated from the market for tax planning reasons and due to the uncertain tax environment.
Municipal finances remain stressed, but signs of stability are emerging. The municipal budget landscape continues to improve through a combination of revenue increases and expense reductions via service cuts, layoffs and renegotiations of employee contracts and benefits.
Market technicals, largely low net new supply, have supported the market. Refundings (i.e., refinancing) represented nearly half of the year’s new supply and support the market by lowering interest costs and replacing — not adding to — existing supply. Net new supply is not expected to increase dramatically in 2013.
Municipal bonds remain exempt from federal taxation. Because it is what investors keep that counts, assets that produce income exempt from taxes are attractive in any scenario. After-tax municipal yields are greater than those offered by Treasuries, agencies and single-A-rated corporate industrial and financial bonds. Furthermore, recently enacted higher tax rates further enhance the attractiveness of tax-exempt income, especially versus other income-producing securities. (The municipal interest exemption was retained in the latest round of fiscal cliff negotiations, but it may be considered in the context of pending tax reform discussions.)
Importantly, we believe that when investing in municipal bonds – a disaggregated market with tens of thousands of borrowers — thorough credit research and monitoring are critical. Independent research enables investment professionals to earn higher yields by investing in longer maturity and lower credit quality securities, areas of the market in which individual investors may not be comfortable.
* Corporate yields are represented by single-A rated corporate industrials and single-A rated corporate financials.
** Assumes a federal tax rate of 35% and no state taxes. State taxes may be applicable and can further reduce the returns of the corporate bond investments (depending on the state of residence). Income from certain tax-exempt securities may be subject to the federal and/or state alternative minimum tax for some investors. In addition, federal and state income tax rules will apply to any capital gain distributions and gains or losses on sales. When investing in municipal securities, investors in higher tax brackets can receive a greater tax benefit than those in lower tax brackets. While the above securities presented are bonds, each provides access to different markets and corresponding benefits. Municipal bonds provide income exempt from federal and state taxes. Treasury and Agency bond income is generally state-tax-free and Treasuries are backed by the U.S. government in terms of a guaranteed and timely payment. Also, corporate bonds provide exposure to the corporate market.
† Source: Barclays Municipal Bond Index. The Barclays Municipal Bond Index is an unmanaged index considered representative of the tax-exempt bond market.
Indices are not managed and do not incur fees or expenses. It is not possible to invest directly in an index.
Equities are affected by stock market fluctuations that occur in response to economic and business developments.
There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer term securities. Non-investment-grade securities, commonly called “high-yield” or “junk” bonds, have more volatile prices and carry more risk to principal and income than investment-grade securities. Income from tax-exempt investments may be subject to state and local taxes, and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal income tax rules will apply to any capital gains distribution.