Just when the demand for municipal bonds was reaching a fever pitch, the rating agency Fitch stepped in and put a damper on the rally. From September 14 through the end of November, the largest municipal bond ETF - iShares S&P National AMT-Free Municipal Bond Fund (ticker:MUB) - rallied 3.4%, due in part to the prospect of higher taxes in 2013. High yield munis performed even better, as gauged by the 3.95% return for the Market Vectors High Yield Municipal Index ETF (HYD). That rally came to an abrupt halt this week after Fitch stated that local governments continue to face financial challenges, and that it expects to downgrade the ratings of "dozens or even hundreds" of issuers in 2013, as reported by the Financial Times on December 3. The main problem is expenses continue to expand faster than revenues, reducing local governments' flexibility - an issue that is being exacerbated by slow economic growth.
The outlook at the state level was somewhat better. In an interview on CNBC, - Laura Porter, Managing Director at Fitch Ratings - said that "States are fundamentally very strong credits. They have strong control over their revenue and spending, and they have shown the ability and willingness to adjust (to the slowing economy)." Still, lower-rated states such as California and Illinois may face trouble in 2013, particularly if federal spending is cut as a result of the fiscal cliff.
The municipal bond market sold off modestly following the Fitch report, but the market was due for a pause after such a strong rally through the autumn. Still, this is an issue that investors will want to watch closely as we move into 2013.
Learn more: 2013 Municipal Bond Outlook.