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Fixed Income Investors Could Benefit from Muni Bonds in Rising Rate Environment, Standish Says

Have Produced Positive Returns During Most Periods of Tightening 

Investments such as municipal bonds that have a yield advantage over Treasuries are likely to be among the fixed income segments that could provide outperformance in 2014 as U.S. Treasury yields start to move higher, according to the municipal bond outlook for 2014 from Standish Mellon Asset Management Company LLC, the Boston-based fixed income specialist for BNY Mellon.

"Excess yield cushions the impact of gradually rising rates," said Christine Todd, president of Standish and an author of the report.  "Municipal bonds generally have produced positive total returns, even during periods when the Federal Reserve is tightening monetary policy by raising short-term interest rates."

One risk to municipal bond returns in 2014 could be liquidity, which might be strained by actions of investors, issuers and regulators, the report said.  In 2013, negative returns precipitated mutual fund redemptions, which led to forced selling by fund managers, the report said. The lack of clarity over federal regulations also limited the willingness of many financial institutions to commit balance sheet resources to municipal bonds, reducing the depth of the market's support, Standish said. 

However, Todd noted, "Individuals and banks continued to buy municipal bonds during 2013. Individuals and banks historically have demonstrated an appetite for tax-free municipal bonds whenever the yields of these bonds have climbed substantially above the after-tax yield from Treasuries."

Over the long run, Standish expects to see an increase in municipal bond issuance to help meet the need for infrastructure investment.  That would reverse the low levels of issuance of the last three years, brought on by austerity programs at the state and local governments, the report said. Standish expects new issues to support infrastructure will be longer term as infrastructure programs tend to take several years to complete.

Todd noted that the tax benefits of municipal bonds will continue to appeal to individual investors.  She said, "As investors begin their 2013 taxes, they are likely to be cognizant of the tax burden on taxable interest income."