As 2015 drew to a close amid dour headlines and gloomy predictions, many equity-focused investors may have missed the brighter story of the municipal bond market. Troubles in places like Puerto Rico and Chicago made for splashy headlines last year, but many state and local governments were quietly making progress that was reflected in positive muni market performance. Rafael Costas, co-director of Franklin Templeton Fixed Income Group’s Municipal Bond Department, offers some thoughts on why munis could continue to attract more investor interest this year.

In 2015, the municipal bond market benefited from a favorable combination of three influences that have historically driven performance: supply, demand and credit quality. We see these positive influences likely to continue in 2016. In the years since the 2008-2009 financial crisis (including last year) new muni supply remained subdued, as local officials around the country tried to get their financial houses in order during and after the Great Recession (which began in December 2007 and ended in June 2009). Many remain reluctant to take on additional obligations even with rates as low as they are today. Meanwhile, demand has been pretty good, especially toward year-end 2015 as the equity markets began to exhibit heightened volatility, and many investors started shifting some of their assets to fixed income.

We expect that supply should continue to be adequate, similar to last year’s levels, and it stands to reason that with the volatility we’ve seen in equities and the concerns about recession globally, demand also should be a positive in terms of cash flows into the fixed income market generally and munis in particular. On a tax-adjusted basis, we think munis still look relatively attractive, especially when considering their quality and stability.

In terms of credit quality, the muni market continues to recover from the Great Recession. It hasn’t been a spectacular recovery—and we still have problem issues such as Puerto Rico—but the overall credit situation generally has been improving or is at least stable. The market has learned how to better differentiate between bond issuers and weed out the few problem spots. Munis overall appear pretty stable in quality; there haven’t been any huge upgrades in the last few years, but the trend has been one of general improvement in quality and slow but steady growth.

Puerto Rico is still considered an outlier in the market. Members of the US Congress are working to come up with a legislative package that addresses things like a financial oversight or a financial control board for the commonwealth that we believe would ideally be independent and federally mandated. There is also still the question of whether to allow access to Chapter 9 restructuring capability for some other agencies there—currently, Puerto Rico’s municipalities and agencies are excluded from Chapter 9 of the US Bankruptcy Code.

As background, Franklin Templeton has been an investor in Puerto Rico bonds for more than 30 years, as these bonds have been part of the investment opportunity set for state-specific municipal funds because of their triple tax-free status (exempt from federal, state and local income taxes.) Beginning in 2012, we began reducing exposure to Puerto Rico-related bonds due to the weakening financial conditions on the island. We retained those investments that we believed were in the strongest position and felt had significant legal and constitutional protections by their indentures and the Puerto Rico constitution itself. See the most recent detailed breakout of the Puerto Rico-related holdings in our Franklin Municipal Bond Funds (Tax-Free Income Funds).1

In June 2015, Puerto Rico’s governor announced that its debt was “not payable” under current terms. We had challenged Puerto Rico’s local bankruptcy law (the Debt Enforcement and Recovery Act, or DERA), which was passed in June 2014. After we won decisions at the local and appellate level, we learned more recently that the US Supreme Court decided to hear the case, which is scheduled to take place on March 22, 2016. We are obviously following developments there closely. If interested in more detail on the situation in Puerto Rico, you can visit our web site for updates.

Impact of Oil and Rising Interest Rates

Oil prices certainly have been a big issue for many market watchers over the past year, but they don’t really affect the overall muni market too much. A few states like Texas, and North and South Dakota have benefited from higher oil prices; in recent years robust shale oil production has fueled North Dakota’s economy in particular. However, the state is not a big issuer of municipal bonds, so we don’t believe that a difficult situation there should really have much of an impact on the overall muni market. If depressed oil prices continue to negatively affect stock prices, then indirectly that could fuel flows into the fixed income markets—including munis—as investors become more risk averse.

In terms of rising interest rates, which many have been anticipating for some time, the impact on the muni market depends on a number of factors, including overall economic activity and inflation. Just a few months ago, it seemed like everyone was expecting the US Federal Reserve to start a new cycle of monetary policy tightening, and it finally moved to raise short-term interest rates in December 2015. At that time, market expectations were for three or four more interest- rate increases in 2016. Those expectations quickly changed as fears about the health of the global economy surfaced. Our overall view is that as long as inflation remains subdued and concerns linger about the health of the economy, investor flows will likely continue into fixed income. We’re not overly concerned about the prospect of rising long-term rates on the muni market in the foreseeable future.

While we certainly try to make our own assessments and predictions, no one can know with absolute certainty what is going to happen with interest rates, the global economy or equity markets in the year ahead. For that reason, we think it makes sense for most investors to consider heeding a message of diversification. While diversification doesn’t guarantee profits or protect against risk of loss, investors who diversify their portfolios won’t likely get overexposed to one area. Sometimes, that idea gets ridiculed as investors look for the next “big thing.” But in our view, diversification can soften the blow if that “big thing” turns into a “big bust.”

The comments, opinions and analyses expressed herein are personal views of the investment manager and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region, market or investment.

This information is intended for US residents only.

What Are the Risks?

All investments involve risks, including possible loss of principal. Because municipal bonds are sensitive to interest-rate movements, a fund’s yield and share price will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in a fund adjust to a rise in interest rates, the fund’s share price may decline. To the extent a fund focuses its investments in a single state or territory, it is subject to greater risk of adverse economic and regulatory changes in that state or territory than a geographically diversified fund. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. A fund may invest a significant part of its assets in municipal securities that finance similar types of projects, such as utilities, hospitals, higher education and transportation. A change that affects one project would likely affect all similar projects, thereby increasing market risk.

Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. Download a prospectus, which contains this and other information. Please carefully read a prospectus before you invest or send money.

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1 For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable.

© Franklin Templeton Investments

© Franklin Templeton Investments

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