The $3.7 trillion municipal bond market has been on a solid two year run with a 20% gain, according to Bof A Merrill Lynch data. Analysts at Morgan Stanley now predict that investors need to brace themselves for the first year of losses within this sector, including focused muni-bond exchange traded funds.
“The margin for error is so thin,” Michael Zezas, Morgan Stanley’s head muni strategist, said in a report. “With yields being at the historical lows they’re at, it only takes a small move higher in those yields before you realize negative returns.” [Muni Bond ETF All Time High Triggers Bubble Fears]
Interest rates on Treasuries are predicted to rise in 2013 with yields on a 10-year Treasury note anticipated to hover around 2.23% by the same time nest year, reports Brian Chappatta for Bloomberg. Currently the rates are at 1.59%. Investors are left with out any cushion to protect them from rising rates, and any small gains made in the rate will cut into the interest income on a muni-bond ETF and create a negative return. [PIMCO ETF Manager Bill Gross Buying Munis on Looming Taxes]
Furthermore, rising tax rates next year would make muni-bonds more attractive because their income is tax-exempt. However, there is talk in Washington of taking away this tax-exempt status. The possibility of this is not high, as removal of this status would do more harm than good. There is the possibility that Obama will increase the top federal income-tax rate to 39.6% from 35%. Based on the potential tax hikes, analysts predict that municipal bonds could still outpace Treasuries in 2013. [Is the Tax-Exempt Status of Muni Bond ETFs in Jeopardy?]
“We can’t envision a scenario in which muni yields would hold while U.S. Treasury yields moved that much higher,” Michael Zezas said. “You’d be looking at muni-Treasury ratios that historically have not been observed.” Zezas expects a negative 1 percent total return in 2013. The muni market has gained for four straight years. [Will New SEC Chief Walter Derail Muni Bond ETF Rally?]
Muni bond ETFs include:
- iShares S&P National AMT-Free Municipal Bond Fund (NYSEArca: MUB) The largest ETF in this sector, with $3.5 billion in assets; Yields 1.50%
- SPDR Barclays Capital Municipal Bond (NYSEArca: TFI) Yields 1.51%
- Market Vectors High Yield Municipal Index (NYSEArca: HYD) Yields 4.26%
- SPDR Nuveen S&P High Yield Municipal Bond (NYSEArca: HYMB) Yields 4.12%
Tisha Guerrero contributed to this article.