As students around the country return to the classroom, it strikes me that now may be a good time to get back to the fundamentals on the municipal bond market as well.

The summer was a fairly tortuous one for the asset class, with the S&P Municipal Bond Index having lost 5.57% between June and August. In fact, most fixed income sectors struggled as interest rates spiked after the Federal Reserve’s first hints of easing off quantitative easing. Notably, the volatility in the muni market over the past few months has had a lot to do with rates — and very little to do with credit events (even big ones like Detroit).

Despite the volatility and headline noise, in my opinion, the reality is that the fundamentals underlying the municipal market are stronger than they have been in five years. A big statement? You bet. And here are just a few reasons to believe it:

State revenues have seen one direction — up. States have notched 13 consecutive quarters of rising tax collections, according to data from the Rockefeller Institute. Preliminary data for April and May indicates that a 14th quarter of improvement appears to be in the making. While revenues have increased, expenditures generally have been well contained as states continue to function with a level of fiscal discipline that had been passé prior to the 2008 financial crisis. The Institute notes that state and local governments trimmed more than 680,000 jobs since August 2008, and are likely to continue “doing more with less.” Higher revenues and lower expenditures is a fiscally powerful combination that has been leading to balanced budgets and increasing reserves nationwide.

Moody’s upgrades its outlook for states. Moody’s recently revised its outlook on US states to “stable” after five years at “negative.” In addition to citing improving revenues and reserves, the agency also noted in its announcement that credit quality among US states remains “extremely high,” with 30 of the 50 states having the two highest possible ratings. In fact, as I noted in my post “Three Pictures Paint the Big Picture in Muniland,” the municipal market overall is relatively high quality, with an average rating of AA as of year-end 2012.

Stronger housing = stronger locals. While the recovery across local governments trails that of states (Moody’s maintains its negative outlook for locals), we would point to strengthening housing prices as a promising omen for locals. Property taxes make up the lion’s share of local revenues and, as such, strength in housing bodes well for local governments. The National Association of Home Builders’ First American Improving Market Index found that 291 metropolitan areas across the country qualified as improving housing markets in September, a gain of 44 markets from one month prior.

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