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Laurie King

Municipal bonds and the fiscal cliff deal

AdvantageVoice® Blog—1-11-13
Laurie King

We recently talked with Lyle Fitterer, Head of the Wells Capital Management’s Tax-Exempt Fixed Income team, about what the recently passed American Taxpayer Relief Act (ATRA) means for municipal bond investors.

Bond prices rallied in November and then sold off in December.  How much of that change in sentiment was due to anticipation of the fiscal cliff negotiations? And what will the recently passed American Taxpayer Relief Act (ATRA) of 2012 mean for investors?
In December, we cautioned that the logic propelling the November rally was too simplistic because it essentially was, “Tax rates are going up, therefore buy municipals” and didn’t factor in enough of a premium for potential changes to the municipal bond tax exemption.  Now that ATRA has passed, municipals benefited in several ways.  Top income-tax rates will go up.  In addition, municipal interest will not be eliminated as an exemption for higher income earners due to the Personal Exemption Phaseout (PEP), Pease exemptions, and deduction limitations that are now in place as part of ATRA. 

So is the risk to the tax-exempt status of municipal interest no longer a worry?
ATRA is only the beginning of what will likely be an ongoing fiscal dialogue. The upcoming debt ceiling and sequester debates will keep potential changes to municipal tax exemption in the news.  Caps on allowable tax-exempt interest or limitations on which entities can issue tax-exempt debt may each influence municipal market technicals and pricing. 

What do you believe will drive municipal bond prices in 2013?
Factors other than tax rates are more influential drivers of municipal valuations. We know this because correlations between municipal/Treasury yield ratios compared to tax rates have been only slightly positive historically. Much more important are the health of the economy and its impact on issuer fundamentals, the overall level of bond yields, and investors’ appetite for risk. These are the primary driver of returns.  We expect each of these will be tested as the federal deficit is addressed by Congress and the White House.  Additionally, the depth of federal spending cuts may affect the credit quality of certain states, regions, or issuers differently.  

2012 was a beta-driven year for municipals because both interest rate risk and credit risk generated outperformance.  We expect 2013 to involve more bottom-up, security selection-oriented decisions to generate alpha.  While credit exposure may benefit investors again in 2013, developments from the bankrupt or fiscally stressed places like Stockton, San Bernardino, Puerto Rico, and Detroit underscore the need for research as much of the lowest hanging fruit that was available by taking credit risk has already been picked. 

The views expressed are as of 1-11-13 and are those of Laurie King, Lyle Fitterer, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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