As fiscal cliff negotiations come down to the wire, one asset class that has been sought as a relative safety play – municipal bonds – is coming under fire. With the recent deterioration in muni prices, my team has been fielding a number of questions from clients who are wondering what’s behind the selloff.
Uncertainty around taxes in 2013 is certainly one of the key drivers. President Obama’s most recent proposal lowers the value of many tax deductions and tax breaks – including the tax-exempt status of munis – for high income households. As changes to the tax treatment of munis seemed less likely in the fall, the latest market move is an unpleasant holiday surprise for many investors. Prior to this development, munis had been a benefactor of fiscal cliff concerns. For example, the iShares National AMT-Free Muni Bond ETF (MUB) has seen $250mm in inflows since November 1st, partially due to investors believing munis would remain tax-free in the midst of a variety of proposed tax hikes or limitations in deductions.
But there are also a few other factors driving the selloff. First, supply of new bonds in December has been higher than expected, with the 30-day visible supply peaking at $13bn on December 11th. Also, some clients are looking to take profits (and capital gains) on municipal positions that have appreciated significantly this past year. And finally, as is typical this time of year, dealers may be reigning in liquidity as they may not wish to hold significant amounts of inventory going into the year-end cycle. With more sellers than buyers, prices have fallen on municipal bonds.
It’s at times like this when the benefits of the ETF structure have a chance to shine. During these types of market corrections, the ETF structure provides transparency and allows for price discovery in an often opaque and illiquid asset class. Municipal bond prices may continue to be volatile until Washington provides clarity on the tax treatment, but in the meantime, the price of municipal bond ETFs such as MUB can provide timely insights into investor sentiment during this period of uncertainty.
Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.