As the market prepares to ring in the New Year, municipal experts say they have mostly positive expectations when it comes to interest rates, credit quality, investor demand, and the viability of municipals' tax-exemption in 2013.
At the same time, however, they said they have lingering apprehensions from the potential long-term effects of the fiscal cliff negotiations to the ongoing impact of the overseas financial crises.
Credit concerns will remain of utmost importance for many municipal players as 2013 nears.
"We think that one of the most important things investors can do is to pay close attention to the credit quality of their holdings," said Tom Kozlik, director and credit analyst at Janney Montgomery Scott.
He said the firm is "very bullish" from a relative value and credit perspective particularly in the single-family housing sector because of its significant premiums to the Municipal Market Data benchmarks.
However, he also warns there could be "several macro-level factors," such as the lack of lawmakers' political will, overall lower economic growth, and probable downgrades that have the potential to affect municipal credit quality in 2013. "Investors need to be aware, plan, and adjust accordingly," Kozlik added.
"Credit will improve, but credit work will still be at the forefront," agreed Jim Pass, managing director at Guggenheim Partners LLC, a New York and Chicago-based asset management, investment banking, and financial services firm. "Regardless of economic conditions, credit is always a concern," he said. "We will continue to shy away from covenant-light transactions and focus on bonds secured by dedicated revenue sources."
"I would expect to see tax-exempt to taxable ratios decline as the credit fear associated with state and local governments dissipates," said Nat Singer, managing director at Swap Financial Group LLC, a South Orange, N.J.-based independent swap advisor. As of Monday, 30-year municipals were yielding 94.4% of the comparable Treasury yield, according to MMD.
Meanwhile, while low rates will usher in the New Year, a public finance banker at a large Wall Street firm, said there are expectations of limited supply, strong demand, and higher tax rates at the upper-end of the income distribution curve.
"Off-setting all that is a growing probability of a cap on deductions as part of the cure for the fiscal cliff, as well as the possibility of other attacks by proponents of fundamental tax reform," he said.
Otheres are worried about how government policy-making will affect the municipal market in 2013.
"We obviously are paying close attention to the rhetoric coming out of Washington as we realize the tax-exemption is on the table" for the first time in 25 years, said Peter Hayes, managing director and head of the municipal bond group at BlackRock, which had more than $106 billion of municipal assets under management in October.
"While we assign a very low probability that the tax-exemption is done away with altogether, we also believe it is naive to think that as greater tax reform is discussed in the future, that the municipal market will not be impacted in some fashion," he explained. "Recent events such as Hurricane Sandy however, highlight the importance of the tax-exempt market," Hayes continued.
"It facilitates an efficient avenue for state, and especially, local governments in this case to access much needed capital for infrastructure and overall capital needs."
Pass shared Hayes' view.
"Tax reform will be critical as we are confident there will be many stops and starts throughout 2013," he said. "Generating current income for our clients will be critical, given the interest rate environment."
Overall, Hayes forecasts that 2013 could produce some of the same themes that drove performance this year but to a much lesser degree.
"Performance will be a sliver of 2011 and 2012, but what is important is that the fundamental characteristics will remain in place -- these being a safe asset class offering minimal volatility, income and capital preservation being a larger portion of total return, and the tax-exempt benefit at a time where taxes are going up," he predicted.
"We anticipate the first quarter will bring further uncertainty, which will bode well for the asset class; favorable demographics in the U.S. [that will] attract a larger audience for high-quality fixed-income securities," Hayes continued.
He said there is also concern over the longevity of positive fund flows -- which aided performance in 2012 as well as the direction of interest rates.
"Any small back up in such a low rate environment can have a bigger negative impact on price," he added. "If flows do stop, what type of adjustment will it take to attract other types of investors?"
Mike Pietronico, chief executive officer at Miller Tabak Asset Management, on the other hand, is predicting a municipal bond market where yields are low, but volatility remains rather muted. "We suspect with tax rates poised to move higher, the tax-free bond asset class will remain well supported," he said.
One of the firm's chief concerns going forward is the U.S. resembling Europe's debacle while fiscal cliff negotiations over the future of taxes approach the year-end deadline and $1 trillion of spending cuts kick in, he noted.
"America may come to resemble Europe as austerity gets forced upon it by a frustrated bond market that sees deficits growing, and a Federal Reserve that knows seemingly no bounds when it comes to underwriting this country's debt problem," Pietronico forecasted.
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