Municipal bonds, which have a yield advantage over U.S. Treasuries, are likely to be among fixed income segments that could outperform in 2014 as U.S. Treasury yields start to move higher, according to a new report from Standish Mellon Asset Management Co.
“Excess yield cushions the impact of gradually rising rates,” Christine Todd, president of Standish, BNY Mellon’s fixed income specialist, said in a statement.
Todd noted that municipal bonds have generally produced positive total returns, even during periods when the Federal Reserve is tightening monetary policy by raising short-term interest rates.
The report cautioned that municipal bond returns could be at risk in 2014 because of liquidity, which might be strained by actions of investors, issuers and regulators. It said negative returns precipitated mutual fund redemptions last year, which led to forced selling by fund managers.
As well, the lack of clarity over federal regulations limited many financial institutions’ willingness to allocate to municipal bonds, reducing the depth of the market’s support, Standish said.
Todd pointed out, however, that institutions and individuals continued to buy municipal bonds during 2013.
“Individuals and banks historically have demonstrated an appetite for tax-free municipal bonds whenever the yields of these bonds have climbed substantially above the after-tax yield from Treasuries,” she said.
Standish said it expected municipal bond issuance to increase in order to help meet the need for infrastructure investment. That would reverse the low levels of issuance of the last three years, brought on by austerity programs of state and local governments.
The report said new issues to support infrastructure would likely be longer term as infrastructure programs tend to take several years to complete.
Todd predicted that the tax benefits of municipal bonds would continue to appeal to individual investors. “As investors begin their 2013 taxes, they are likely to be cognizant of the tax burden on taxable interest income,” she said.
Check out Biggest Muni Bond ETF’s Premium Grows as Fund Exodus Abates on ThinkAdvisor.