With the recent federal fund rate hike of 25 basis points, 10-year treasuries have now crossed the 2.50% mark. With the possibility of further hikes in 2017, investors are now on the verge of rethinking their fixed-income strategies, including municipal bonds. Recent outflows from the municipal market are the result of a perceived double-edged sword – one that is both low-yielding and entails relatively higher levels of interest rate risk. As a result, many municipalities have halted their refunding and issuance endeavors because some of these transactions no longer seem as lucrative as they used to be.

In this article, we’ll examine the overall impact of rising interest rates, the current state of fixed-income securities from the investor’s and the issuer’s standpoint and trends to watch in the municipal debt space in 2017.

The low-rate environment has served US municipalities well as 2016 has likely set some new precedents for muni bond issuance and refundings in recent history.

As seen below, the total dollar amount of municipal debt refunded in 2016, year to date, has been the highest in the past two decades. This is certainly expected to slow down in 2017 due to rising rates. The tapered supply of municipal debt will also put upward pressure on municipal yields.

In addition, the recent rate hikes have sent many municipalities to reconsider their refunding options. Consider this. A recent Reuters report mentioned that over $338 million worth of municipal debt sales were canceled or delayed due to market volatility in late November. Over 90% of these deals were municipal debt refunding transactions. Before investing in any state specific muni bonds, read about the inherent risks in state muni bonds.

In case you are wondering how to view the most recent muni bond trades, visit our Market Activity section.

Currently, besides the rising rate environment, many municipalities are also facing some serious consequences because of their mismanagement of debt disclosures from the past. Recently, the SEC fined various municipalities debt-related disclosures. Going forward, the SEC is expected to hold investment banks underwriting debts for municipalities accountable for non-disclosure or overlooking material events that should otherwise be publicly disclosed. For some municipalities, these fines and tarnished images may prevent them from accessing the municipal markets for their capital needs in the future.

In addition, under the Trump administration’s tax plan, the Marginal Tax Rate (MTR) will be lowered for high earners from 39.6% to 33%. This is also a key consideration for municipal debt markets, because high earners have always turned to municipal debt for its tax-exempt earnings. If the MTR is reduced, then the overall tax benefits will be reduced for high earners, making municipal debt a less attractive investment option for them.

In 2017, as more rate hikes come into play, debt refunding is definitely expected to slow down. This will provide an organic growth to the new issuance of municipal debt.

Retrospectively, the Trump administration’s expected focus on U.S. infrastructure development programs would be good news for private activity bonds (PABs) in the muni bond space. In the past, the Obama administration has had some failed attempts to attract foreign capital into US infrastructure sectors through Build America Bonds (BABs); however, the new administration has signaled the revival of BABs.

In terms of essential public infrastructure, several U.S. municipalities have shown huge concerns over their growing deferred maintenance costs of water infrastructure systems and deployment of modern distributed water systems. Where Green bonds (for distributed water systems) will take the strain off the traditional distributed water channels, the much-needed changes in public finance laws for distributed water systems will foster an ideal environment for PABs and revenue debt for new water infrastructures. In this context, you can check out the recent trades of green bonds from California (check the CUSIP here) and Massachusetts (check the CUSIP here).

To form a perspective of the potential of muni bond financing in this space, you can check out the prospect of munis in modern water system projects in the U.S.

As bond market volatility is likely to continue in 2017, equity markets are likely to produce better returns. Therefore, diversification will remain the key for average bond investors looking to make significant shifts in their portfolio and mitigate the interest rate risk. In the context of muni bonds, diversification can be achieved through mutual funds, national muni ETFs or state-specific ETS that are composed of bonds with different maturities, coupons and credit ratings.

The discussion between investing in mutual funds or ETFs is a decision each individual should make with the help of their financial advisor, and there are always pros and cons. However, national muni ETFs emerge as the most viable option due to their lower fees compared to mutual funds and are more diversified than average state-specific ETFs.

The significant outflows of capital from municipal bond funds in recent weeks may also be worrisome for many investors and trigger memories of 2013 outflows, but, due to stricter regulations, these funds are better prepared and have enough liquidity to handle these events. In this context, you can learn more about the basic muni bond investment strategies.

To sum it up, investors should keep in mind the following factors:

• Rising interest rates will likely put upward pressure on muni yields in 2017. This would also mean a lesser overall supply, as refunding volume retracts. Tighter disclosure rules could further restrict market access to smaller issuers, putting further pressure on the supply side.

• However, new opportunities could be found around public infrastructure space that are likely to rely on municipal debt.

Municipal debt investors seeking to reduce their portfolio volatility and generate decent returns are likely to achieve this with proper diversification and weigh their options based on risk tolerance and time horizon. This can be achieved by picking or customizing the right muni fund that invests in a wide array of debt instruments to fit your investment objectives.

Be sure to visit our municipal bond News section to stay up to date with the latest market trends.

Moreover, as a premium user, you can also check up the latest Moody’s credit reports for all the municipal bonds listed on our website