The National Perspective
Over the course of 2014, a number of economic and policy variables are likely to impact the municipal bond market. Consensus expectations of the Federal Reserve indicate a gradual tapering of the Fed’s asset purchase program. While the initial market response may be negative, over time more attractive valuations may draw buyers to the market. The long end of the yield curve has flattened while we’ve seen a steepening on the short end. Estimates of the 2014 year-end yield on the 10-year Treasury fall near 3.50%. Municipal bonds remain attractive relative to Treasuries. In this environment, the bond markets could produce low, but positive, total returns for the year.
A number of near-term events could generate volatility in the bond market. During the first quarter, Washington will be required to address the debt ceiling and the Federal budget. In the recent past, these debates, along with the scenario of a disaster narrowly averted, have created inflection points in the bond markets which provided attractive valuations. Although tax reform proposals may emerge this year, it seems unlikely that legislation will be enacted, particularly with legislators focused on mid-term elections. Headline risk is likely to remain a factor in connection with Detroit, Illinois, Puerto Rico and the pension liabilities of individual municipal credits.
At the same time, there are significant positive factors influencing the municipal market. The financial condition of most municipalities has improved with modest economic growth and a corresponding increase in revenues. State tax collections have been growing for over 3 years now, while defaults are occurring at the slowest pace since 2008. Valuations have become attractive and declining new issuance is supporting those valuations to some degree. With the on-set of tax season, as the impact of recent tax changes becomes clear, interest in tax-exempt municipal income is likely to rise. Should rates rise, the municipal tax-exemption becomes even more attractive.
We believe that municipal bonds could outperform other fixed income categories in 2014. In the second half of 2013 the yield on a typical “A” rated municipal bond was at least as much as an equivalent “A” rated corporate bond. This enticed investors seeking total return to buy municipal bonds, even when they did not need the tax advantages of municipal bonds. Another year of anticipated lower municipal bond issuance (reduced supply) and higher tax rates (heightened demand) could make municipal bonds more attractive in 2014.
The Local Perspective: Hawaii
Hawaii’s economy continues to perform well. Unemployment remains at one of the lowest rates in the country. Residential construction continues to advance in addition to the strong tourism and military industries. Hawaii was selected as a FAA drone test site, which will bring additional government funding and technology jobs to the state. Researchers will be looking at ways to safely integrate drones into US airspace along with commercial aircraft.
2014 may be similar to 2013 in some respects. Liquidity and the prospect of a higher rate environment are likely to be factors. Therefore, the Trust will continue to emphasize high-quality credits, reinvesting coupon and maturities into potentially higher yielding securities. Any significant surprise, such as a drastic reversal of the economic recovery, a sudden change in Fed policy, or geopolitical turmoil, may bring heightened volatility.
Before investing in a Fund, carefully read about and consider the investment objectives, risks, charges, expenses, and other information found in the Fund prospectus. The prospectus is available from your financial advisor and when you call 800-437-1020 or visit www.aquilafunds.com.