Is The Municipal Bond Market Going to Rebound?

2012 was a great year for the municipal bond market – it returned a nice 7.3%.  While that is not even half of the 16% that the S&P 500, it was still almost triple the 2.2% that Treasury Bonds returned last year.  Even though there were some bumps in the road in 2012 (most notably, several municipal bankruptcies), the market still performed very well.

So what is driving this $3.7 trillion market?  Well, a whole combination of issues that should bode well for municipal bonds this year as well.  Here’s why I think this market is regaining its footing and should continue to perform well.

Municipal Revenue is Increasing

The dominant source of municipal revenue (i.e. how cities and counties make money) is through property taxes.  So, for revenue to rise, property taxes have to go up.  Two key factors are driving an increase in property taxes across the country: home values are rising and property tax rates are rising.

Rising Home Values

The biggest driver is rising home values.  Finally, after several years of a stagnant housing market, it appears that home values are starting to climb back up again.  The most recent report of the S&P/Case-Shiller Home Price Index saw home values rise by 4.3% through October 2012.  That was the 6th straight month of home price increases, which is a great start.

For most parts of the country, rising home values equal higher property taxes because property taxes change based on the value of the home.  This isn’t the case is some states, like California, but there are other factors at play to increase revenues as well.

Rising Property Tax Rates

Since places like California won’t see an increase in revenue through higher home prices (until the houses are sold), they will need to rely on increasing current property tax rates.  This has also been a successful trend across many municipalities.  Property tax rates across the country are rising in response to an improving economy and a backlog of public projects that need to be funded.  This bodes well for municipal bonds, especially revenue bonds, which are tied directly to property tax funding.

Municipalities are Growing Again

Another positive for the municipal bond market, and revenues for these municipalities is that these cities and counties are growing again.  Cities and counties grow by constructing new buildings, specifically housing.  So, a great indicator of how municipalities is growing is the Housing Starts metric.

For December, housing starts were 39.6% higher than in December 2011.  This is a huge improvement in the new home construction market, and should bode well for cities and counties across the United States.

Another indicator is how many housing projects were completed.  Housing completions were 13.2% higher than in December 2011.  But with the higher number of housing starts, this number is bound to grow throughout 2013.

Municipal Bonds Look Attractive

Beyond the improvements in the fundamentals of the municipal bond market, municipal bonds also look more attractive due to the higher capital gains taxes in 2013.  For higher income individuals, taxes on investment income will be higher this year, and so any advantages to avoid taxes will be looked at by these high net worth individuals.  Municipal bonds continually fall into this category because of their tax exempt status in most localities.

This should see more individual investors moving into the municipal bond market.

Potential Municipal Bond Market Dangers

However, it is important to look at the dangers that will continue to plague the municipal bond market this year.  I already mentioned that several cities in California declared bankruptcy last year, and that potential still exists this year.

Two of the biggest dangers to the municipal bond market include: underfunded pension liabilities and cuts to Federal spending.

Municipal Pension Liabilities

One of the biggest challenges facing municipalities across the United States are their pension liabilities.  For years, working for local governments was a great job because they provided good benefits and solid retirement savings.  However, with budget cuts and poor stock market performances, municipal pension funds across the country are underfunded, and the governments that run them are being forced to pay more out of pocket to get them up to par.

However, many are not able to do so while still providing the basic services they must provide (like police, fire, and other basic services).  As such, they are forced to either restructure their plans or, in more drastic cases, declare bankruptcy.

Cuts in Federal Spending

Most municipalities get about 25% or more of their income from Federal programs.  With the potential budget and postponed fiscal cliff deal looming in Washington, here could be drastic spending cuts impacting thousands of government programs.  The net result of these spending cuts will be less money for local cities and counties, putting even more budget pressures on these municipalities.

Unless the municipalities have sufficient reserves or in-line pension liabilities, there will inevitably be more cuts and potentially more bankruptcies.  As long as the fiscal cliff spending cuts loom, this poses a real risk to the municipal bond market.

A Continued Rebound is Likely

However, despite the risks to the municipal bond market, I believe that the market will continue to rebound and deliver another year of solid performance.

I’m sure that there will still be several bankruptcies that ripple through the market, but high-grade municipal debt will perform well given all of the other fundamental factors at play.

What are your thoughts on the municipal bond market?  Will it rally or fizzle in 2013?