Muni Bond ETF Health Check

The volatility in municipal bond ETFs we saw at the end of 2012 due to speculation on the tax-exempt status of muni bonds and the U.S. fiscal cliff is pretty normal in terms of markets.

Market participants are normally used to seeing corrections, re-settings and re-balancings of opportunities in their markets. The same thing has just happened in the municipal marketplace.

It’s a healthy thing. Investors are going to find yields and opportunities in municipals even more attractive than they were back in October and November. Such has been the correction that’s occurred recently, but it is a healthy correction. [Muni Bond ETFs Keep Tax-Sheltered Status]

Nothing fundamentally has changed, and credit quality remains at the very top of the spectrum relative to other asset classes.

States & Municipalities

The outlook for states and municipalities in 2013 is improving. There are many reasons to be optimistic about the recovery and the health of communities around the country.

Although growth is not robust and we still face significant challenges, all evidence points to increased revenues and tax collections. States and municipalities must balance their budgets.

Constitutionally, they need to produce balanced budgets every fiscal year, which leads to more proactive participation on the part of legislators to actually manage revenues and manage through difficult times. I would say the outlook continues to be fairly positive for all states and municipalities who are issuers of municipal bonds.

Measuring Impacts of Puerto Rico Downgrade

Recently, Moody’s Investors Service downgraded the credit quality of Puerto Rico — the commonwealth’s obligations as well as several other issuers in the commonwealth. The impact of that right now may seem significant because we have had some price dislocation in the market.

Long term, I do think that Puerto Rico, as it is held collectively by almost every investment manager in this country in investment portfolios, will continue to be an important part of strategic allocation in those portfolios. [Muni ETFs Fall on Tax Jitters, Downgrade]

Now that the margin between investment grade and non-investment grade debt is much narrower than in past years, I think that Puerto Rico debt is going to force the new government that has recently been elected in Puerto Rico to address those questions and issues and put the commonwealth back on track to more robust growth and development.

While it might seem like Puerto Rico is under a great deal of pressure near term, I think the commonwealth will respond, and I think that investment managers will continue to — very carefully, as they always have done — monitor the creditworthiness of all Puerto Rico issuance.

U.S. Fiscal Debate

For munis in particular, there is a notion that there may be a cap on the benefit of the tax-exempt coupon. 28% is a number that has been kicked around Washington and that certainly would have an impact and consequences. Also, there is a question as to whether the tax-exemption of the municipal coupon will continue as it is.

In other words, will Congress say, “We have got to find ways to raise more revenue; we have got to balance the budget; we have got to lower the deficit?” One of the ways is to eliminate the deductibility, or the benefit of tax-free income.

If that should happen, there would be untold consequences, one of which might be impacting state and local governments in a meaningful way; their access to the capital markets would be far more costly because these bonds and this access to the capital markets are no longer tax-exempt.

The yields would no longer be at lower levels; they would be at higher levels and cost the states and municipalities more for their programs. One additional point that should not be lost in the debate and the discussion is the impact of taxing tax-free income means, in effect, an additional tax on taxpayers, the general taxpaying population across the country. Many of those people don’t even invest in municipal bonds. Increasing the cost of capital for those municipalities will have a broader impact than perhaps most people are aware.

The question remains: what is going to happen? No one really knows. We’re preparing for the worst and hoping for the best.

James Colby is a portfolio manager and senior municipal strategist at Market Vectors ETFs.