Municipal bonds have been strong performers throughout 2015, leading all categories with total returns of 3% to 4% depending on the index. With record low interest rates, investors looking for yield were drawn to a combination of tax breaks and high yields. Puerto Rico’s debt crisis may have sparked some concerns in the muni market, but all 50 states have a stable rating outlook for 2016 for the first time since the 2008 economic crisis.
In this article, we’ll take a closer look at the municipal bond market and where it may be headed moving into 2016.
Many Reasons to Be Bullish
The municipal bond market has a lot going for it, especially compared to other fixed-income markets like Treasuries or corporate bonds.
Municipal bonds provide tax exemption from federal taxes and sometimes state and local taxes depending on local laws. Since investors don’t have to pay taxes on their income, the equivalent yields of muni bonds are usually higher than their non-tax-exempt counterparts in the Treasury or corporate bond market. Treasury bonds breaking even in 2016 would likely mean muni bonds are providing about a 3% equivalent yield for similar maturities.
The supply of tax-exempt debt has also been steadily declining since 2010. With low interest rates across the board, many bondholders are opting to hold rather than finding higher-yield options in today’s market. Muni bond trading volume has reached its lowest levels this century as buyers rush in and oversubscribe state and locality offerings. These dynamics have tended to keep muni bond prices at a premium compared to Treasuries and other bonds.
While Puerto Rico’s default caused some issues for the muni bond market, credit quality has also been on the rise since the 2008 economic crisis. Fitch Ratings recently indicated that all 50 states have a stable rating outlook for the upcoming year, driven by higher income and sales taxes, rising real estate values and relatively few big problems. As a result, high-yield muni bonds have been strong performers with the exception of Puerto Rico’s bonds.
Some Potential Risks Remain
The municipal bond market may have several favorable tailwinds pushing it forward in 2016, but there are also many risks that investors should consider.
Puerto Rico seems likely to default on its debt after Governor Alejandro Garcia Padilla announced that the territory is rapidly running short on funds. Unless the U.S. federal government steps in to provide bankruptcy reforms, these defaults could impact some areas of the high-yield muni bond market. Many of these risks have already been priced into the bonds, but there’s still some downside risk that remains as some bondholders remain hopeful for a bailout.
While Puerto Rico is largely a headline risk, the Federal Reserve’s decision to hike interest rates could have an adverse impact on fixed income in general. Muni bonds are expected to outperform many other fixed-income classes, but investors may want to consider other asset classes that may be more immune to higher interest rates, such as blue-chip equities. That said, low inflation expectations could keep bond yields in check throughout the first half of 2016.
The Bottom Line
The municipal bond market remains in favor when it comes to fixed-income investments, given its tax-advantaged nature, favorable underlying economics and improving credit quality. While there’s some headline risk from Puerto Rico’s defaults, many of these risks are already priced into the market, which means downside may be limited. However, muni bonds could still suffer a bit from higher interest rates alongside other fixed-income investments.
