There’s no question that last year was a rough one for municipal bond investors. In 2013, the S&P Municipal Bond Index dropped 2.6%. This represented the worst annual performance for muni bonds since 2008 and was just the fourth losing year for munis since 1990. According to Morningstar Inc., the $4 trillion muni bond market suffered net withdrawals last year of $48.5 billion.
So does this portend more pain for muni bond investors in 2014? Or will munis once again provide the steady gains they offered investors over much of the previous decade?
How Muni Bonds Work
Municipal bonds are fixed-income investments offered by states, cities and counties to raise money for public projects like schools, hospitals, roads and bridges. Typically, issuers make semi-annual interest payments to bondholders at a fixed rate, repaying the principal in full on a future “maturity” date. Less frequently, “zero coupon” bonds are issued. These bonds are sold at a substantial discount from the face amount, with all interest and principal paid upon maturity.
One of the biggest benefits of muni bonds is their tax-free status. Interest earned is generally exempt not only from federal income tax, but state and local income tax as well (for residents of that city or state). This can make muni bonds a very attractive after-tax investment for the right individuals.
But muni bonds come with risk. One of the biggest is interest rate risk: When rates rise, muni bonds fall in value because existing bonds will be paying a lower yield relative to the yield offered by newly issued bonds. An anticipation of rising interest rates was one of the factors behind their poor performance last year — and that same fear has some investors spooked about what might be in store for muni bonds this year.
While few question the inevitability of interest rate hikes, many analysts say their potential impact on municipal bond performance will depend on how quickly rates rise, and by how much. If the Federal Reserve manages a gradual rise in rates over time, the damage to the muni bond market could be muted. But a rapid rise in rates this year would definitely spell trouble for muni bond investors.
What About Credit Risk?
The other main risk of municipal bonds is credit risk; or, in other words, the risk that the bond might be downgraded or the issuer might default and not repay the principal. Despite several high-profile municipal bankruptcies like Detroit, though, some analysts say the fear of municipal defaults is overblown. For instance, defaults are currently down as the improving national economy boosts tax revenues for many cities.
One factor that could boost muni bond prospects in 2014 is the new 3.8% Medicare surtax that is part of Obamacare. This tax will be assessed on various forms of investment profits for high-income couples and individuals. However, muni bond income is exempt from the Medicare surtax, which could make munis more attractive to these couples and individuals.
Are Munis Right for You?
So, should you venture into the muni bond waters in 2014 — or avoid them like the plague? The answer depends on such factors as your investment goals and timeframe, level of risk tolerance, and your desired mix of assets in your overall portfolio. Every investor’s circumstances are different, so you should consult with an investment advisor for guidance about your particular situation. That said, most experts are predicting a continuing, gradual rise in interest rates during 2014. And because bond values fall when interest rise, the bond market this year should certainly be approached with caution.