Supply and demand technicals are also making municipal bonds attractive going forward. While investors have been demanding more munis, as evidenced by the above chart, municipalities are issuing less debt.  The BlackRock Investment Institute estimates a decline of the amount outstanding in the muni bond market by $25 billion annually in the next 3 years. With fewer new infrastructure projects and a decrease in local spending, there is less need for municipalities to issue more bonds. Such a scenario would result in less supply, which would pressure prices higher and yields lower.

What does it all mean? Given today’s attractive valuations, tax benefits, and the outlook for supply and demand, we currently favor munis relative to other sectors of the bond market. While the fiscal cliff is a cause of uncertainty, there may be a silver lining in municipal bonds.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.

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