After a rewarding year for many municipal bond investors in 2012, there is some uncertainty about what 2013 may have in store. Therefore, some perspective on relative value trends, recent market developments, and particular issues that might affect the asset class could help investors identify this year's potential investment opportunities.

1) Proper Perspective for Relative Value
Although 2012's strong market performance resulted in a flatter yield curve and tighter credit spreads by the end of the year, these metrics should be viewed from a longer-term perspective. This is because the capital markets have been in an unprecedented environment during the economic recovery, and investors evaluating the market in the context of only the past five years could miss further opportunities.

For example, one of the most visible signs of the Federal Reserve's policy accommodation has been the steepness of the yield curve relative to its historical levels. Despite last year's significant outperformance of the longer-term portion of the market, the municipal yield curve stood at about 280 basis points (bps) to start 2013. This was still 10 bps steeper than the long-term average.¹ Yet the recent level appears even steeper when considering that it was less than 50 bps in early 2007, which was before the Fed started its aggressive policy accommodation. The portion of the curve consisting of 10- to 30-year maturities is even steeper compared with historical averages.

Similarly, the extreme market dislocation of 2008 left credit spreads extraordinarily wide. And even after tightening last year, the yield spread of 'BBB' rated muni bonds to the yields on 'AAA' rated muni bonds was 220 bps at the end of 2012, 96 bps wider than the long-term average² (see Chart 1). Also, the spread of high-yield muni bonds over investment-grade munis was 350 bps at the end of last year, 73 bps wider than the long-term average.³

This year also started with benchmark municipal yields that were below those on Treasury rates, which is a notable difference compared with the past couple of years, when the tax benefit on municipal bonds was essentially discounted. In examining relative value, it could be overlooked that before 2008, it was an extremely rare occurrence for municipal yields to exceed those on similarly dated Treasury securities. Therefore, having lower municipal benchmark yields compared with Treasuries to start 2013 is really just a reversion to the long-term tendency and may be a more accurate reflection of the historical value that investors have placed on munis' tax benefits.

It is also important to recognize that the yield comparison above is based on benchmark municipal indexes. And almost all municipal bonds trade at yields that are higher than the benchmarks, meaning their yields may still be higher than those on similarly dated Treasuries.

2) Watch for Headlines
The outcome of Washington's ongoing fiscal drama has broad implications, and the municipal bond market continues to be directly affected. While the recent tax package could be considered largely positive for the municipal bond market, there are other fiscal issues that will require negotiation and may not have a similar outcome. (See consideration 5 for additional ramifications of the American Taxpayer Relief Act of 2012.)

Indeed, if one now views the "fiscal cliff" as consisting of two parts—the first regarding revenues and the other regarding spending—then it was a significant positive that the recent tax package did not include a previously suggested 28% cap on the exemption for municipal bond income. Given the unpredictability of Washington, however, this is an issue that could resurface, and new headlines about an exemption cap could negatively affect the market.

Also, although the delay in the spending side of the fiscal cliff was positive, the rhetoric about spending cuts will intensify as March approaches, which is when the spending cuts previously agreed upon are scheduled to occur. If spending cuts are enacted, they will need to be examined for their potential effect on municipal budgets and certain tax-exempt sectors.

Investors should also expect additional headlines about underfunded pensions and municipal bankruptcies. While both issues are serious, they deserve some context. To start, most states are considered to be sufficiently funded, but the news reports will focus on the handful that are not. Also, the worst pension issues, such as those in Illinois, are not current issues for the market. This does not mean that pension deficits should not be dealt with immediately, but, in most cases, it will be years before the liabilities will need to be paid out. Delays in dealing with pension issues, however, could contribute to credit rating downgrades.

Another municipal bankruptcy would generate headlines, but it is important to recognize the rarity of Chapter 9 filings. After all, the California cities that are currently in bankruptcy—San Bernardino and Stockton—are only two among 482 municipalities in the state. In addition, ongoing credit research could assist investors in avoiding not only those municipalities that are bankruptcy risks but also those that are facing consistent economic deterioration.

3) Tangential Factors in Play
In addition to the municipal bond market's idiosyncratic issues, it also faces some factors that can affect the broader capital markets. Of those factors, monetary policy has perhaps had the most significant effect. And although this policy accommodation appears set to continue through 2013, it deserves constant monitoring.

The prospects for further Federal Reserve accommodation are based on its recent decision to tie the fed funds rate to an unemployment rate of 6.5% and an inflation target of 2.5%, both of which remain firmly in the distance from their current levels. In addition to keeping short-term rates low, the distance to those targets should also continue the Fed's quantitative easing initiatives through the first half of 2013 at the very least, thus potentially keeping long-term rates near their historically low levels.

Economic growth is expected to continue, albeit at its current, relatively sluggish pace. If the pace of growth were to accelerate, this could prompt the Fed to curtail some of its asset purchases, and, consequently, long-term rates could move higher. This scenario could potentially benefit the more credit-sensitive segments of the municipal market because a strengthening economy should improve overall credit quality and consequently tighten credit spreads.

Another issue that could affect certain segments of the municipal bond market is the implementation of the Patient Protection and Affordable Care Act, which is scheduled to be in place by January 2014. There are some widespread uncertainties about how the various components of the act will be enacted, which could affect the healthcare/hospital portion of the municipal bond market. Still, hospitals have been given a lot of lead time to prepare for these changes, so most of them should be well positioned for the Affordable Care Act's eventual implementation.

4) Reading the Tea Leaves
The combined prospects for headline events that are specific to the muni market and the broader factors that can affect all the capital markets support some expectations we have for the muni market in 2013.

• Assuming that the Fed's policy efforts to keep interest rates range-bound are successful, total returns on municipal bond investments should approximate their current yields and could be slightly higher since there are opportunities for positive price performance from relative value opportunities. For reference, the tax-equivalent yields⁴ for investors in the 39.6% tax bracket ranged from 5.50% on the Barclays Municipal Long Bond Index⁵ to 9.37% on the Barclays High Yield Municipal Bond Index,⁶ as of December 31, 2012. These tax-equivalent yields ranged from 4.61% to 7.86%, respectively, for investors in the 28% tax bracket, and each investor's tax bracket will determine the tax-equivalent yields they may receive.
• If long-term interest rates remain in their current range, this year's municipal bond issuance should remain consistent with 2012's total volume of $374 billion. But when refinancing issuance is excluded from that total, the market only received $148.6 billion in new securities, which was about 3% less than in 2011⁷ (see Chart 2). The large volume of refinancing-related issuance underscores the risk that individual investors are facing when their bonds are being called away, thus leaving them with the challenging task of reinvesting the returned principal in the current low-rate environment. This issuance trend is likely to continue, therefore leading to negative or limited changes in the net supply of outstanding municipal bonds.
• As long as interest-rate volatility remains subdued, which is likely given the Fed's various policy initiatives, municipal bond demand should be strongly positive. More than $50 billion flowed into the asset class in 2012.⁸
• If economic growth continues at its current pace or better, credit quality across the country should remain consistent with its historical stability. This would continue the trend from 2012 when the municipal bond market saw its fewest number of defaults in three years.⁹

5) Areas of Opportunity in 2013
Municipal bond opportunities in 2013 could begin with the overall asset class itself for tax-sensitive investors in the upper tax brackets. After all, the recently passed tax package (the American Taxpayer Relief Act of 2012) phases out some exemptions and limits deductions. For many investors, these adjustments may underscore municipal securities as one of the remaining viable tax havens.

At the higher household-income levels, those making more than $450,000 could have an effective tax rate of 43.4% when considering the recent increase in the marginal tax rate to 39.6% and the 3.8% Affordable Care tax on investment income that begins in 2013. The increase in the effective tax rate could translate into a tax-equivalent yield of 5.87% on the Barclays Municipal Long Bond Index, which was about 258 bps above the taxable yield on a 'BBB' rated segment¹⁰ of the corporate bond market, as of December 31, 2012.

It is also important to remember that the Affordable Care levy applies to households making more than $250,000. Therefore, these additional taxes could actually mean that these households have a tax rate that is close to the previous top rate of 35%.

In addition, state income taxes could also rise, such as in the case of California's recent increase in income taxes. As a result, investors in higher-tax states could also find enhanced opportunities in tax-exempt securities, particularly those issued from entities based in their state of residency. [It is important to note, however, that municipal securities may be subject to the alternative minimum tax, and, in certain cases, federal, state, and local taxes may still apply.]

Based on the previous considerations, the specific areas of opportunity within the market in 2013 could include:

• Investment-grade bonds with credit rating below 'AA.' Credit spreads are still wide compared with historical averages, and credit quality is improving with the economy. This opportunity requires thorough research to widen the investable universe, while maintaining surveillance over existing positions. For those willing to assume the risk in the high-yield portion of the market, this opportunity also extends to these securities as well.
• Given the steepness of the yield curve, it would take a significant surge in long-term interest rates in order for short-term securities to outperform longer-term bonds. This is because it would take a significant differential in price performance to offset the incremental income of longer-term bonds. Therefore, the long-term portion of the market could continue to outperform, but with potentially more volatility.
• Bonds with maturities of 21–25 years represent the steepest part of the yield curve for long-term securities. Therefore, the potential combination of extra income and total return as the securities roll down the yield curve suggests opportunity for excess returns without needing to extend to the market's longest maturities.
• Bonds with 10-year maturities are positioned in the steepest part of the overall yield curve. This may be the strongest part of the curve when considering the potential for total return versus interest-rate risk because the price performance from rolling down in maturity could offset a large portion of the incremental tax-exempt income that may be earned by investing in longer-term bonds.
• Some bonds in housing-related sectors may present opportunities as the housing market improves along with the economy. If home sales continue to accelerate, some sectors that are backed by revenues from increasing real-estate values, or that benefit from a housing market recovery, could appreciate. This includes tax-revenue bonds where the taxes come directly from real estate, or other projects that benefit from the increased ability of consumers to sell their homes.