Municipal bonds remain attractive even after their divergence from Treasuries this past week, industry watchers say, suggesting the recent signs of strength in the market may carry into the new year.

Muni ratios to Treasuries have tumbled into richer territory as tax-exempt yields have outperformed those of Treasuries. But there remain many spots along the yield curve, and many different credit levels, at which investors may choose to put their money, analysts and fund managers said.

"Municipals, even though they've rallied compared to their taxable counterparts, remain at this point, fair value," said Jeff Timlin, principal and lead muni portfolio manager at Sage Advisory Services.

Adding to the attractiveness of tax-exempt yields, issuance is forecast to remain subdued for the year, while tax rates are likely to rise.

Seasonal effects account for some of the divergence between muni and Treasury yields Timlin said. These include large coupon and principal redemptions in January, as well as money that needs to be redeployed from other asset classes that sometimes flows into the municipal market.

"New-issue supply coming to market is, and probably will continue to be, limited for the foreseeable future," he said.

In absolute terms, new issuance will decline in 2014, said Mikhail Foux, municipal analyst at Citi. And as taxable muni issuance is also expected to climb this year, he added, tax-exempt issuance is likely to continue its slide.

Since the new year started, triple-A tax-exempt yields have fallen eight basis points for the 10-year, to 2.71% through Thursday, Municipal Market Data numbers showed. They've fallen 10 basis points for the 30-year yield, to 4.10%, and slipped one basis point for the two-year, to 0.34%.

By comparison, the 10-year Treasury yield fell two basis points over the span to 2.96%; the 30-year dropped five basis points to 3.87% and the two-year yield rose five basis points to 0.43%.

This has helped drive muni ratios to Treasuries lower, as rates on the latter have risen on strong economic data and a surging stock market. The 10-year ratio since the start of the fourth quarter has fallen to around 91% from a 102% high.

The 30-year ratio has dropped to 106% from 116%, while the two-year has plummeted to 79% from 122% over the span. Market pros say munis remain attractively priced, though investors will have to be more careful about where they put their money.

At its current ratio, the front end of the muni yield curve is rich by any measure, Foux said.

"We don't see much value there," he said. "The 10-year, obviously after this rally, is not as attractive, but it's still decent. It might be relatively rich compared to recent history, but not where we think it ultimately should be. There's still a little bit of room."

The long end of the muni yield curve holds the most value, Foux said. Based on the history of the ratio to Treasuries, there is substantial room for outperformance, he said.

But there are risks there, and investors must pay attention to duration, Dorian Jamison, municipal analyst at Wells Fargo Advisors, wrote in a research report.

As investors seek to increase yield by lengthening the average maturity of their muni bond portfolio holdings, they should monitor their duration, or the weighted average time until repayment, Jamison wrote.

Duration, which is stated in years, measures the sensitivity of a bond's price to a change in interest rates. ASG Municipal Research looks for "a duration target of 7.50 years for tax-advantaged accounts," Jamison wrote. That falls just short of the Barclays Municipal Bond Index of 8.22 years.

Beyond long bonds, high-grade munis with triple- or double-A credit ratings maturing between eight and 12 years occupy a safe spot for investors, Foux said.

"You should not expect a home run,” he added. “Expect 1-to-2% total returns on high-quality names, accounting for the fact that you’ll make some money on your coupon. But you should make more in high yield, so all told, you could have decent total returns in munis this year.”

Looking down the credit scale, however, provides the most value for investors, Foux said. Single-A-rated and, in particular, triple-B-rated credits stand apart. Looking at some triple-B credits issued late last year, he said, those bordering on high-yield are valued at levels comparable to corporate bond yields outright, or regardless of the tax exemption.

But investors are also taking expected increases to tax rates in 2014 into account, Timlin said. Higher tax rates and a cutback in deductions should influence investors' decisions when considering after-tax returns.

"We just had the implementation of the additional 3.8% increase in dividend income for incomes over $250,000, if married, additional 1.9% to the Medicare tax rate," he said. "So, people are seeing the layers of new taxes coming to market. Municipal bonds provide a good risk-reward opportunity, even though those levels have, from a muni-to-Treasury ratio, become less attractive."

James Ramage is a reporter at The Bond Buyer covering municipal bond investing and investors. 

Read more: