01/24/2014

2014 Colorado Municipal Market Outlook

by

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:  Colorado

Colorado municipal bond new issuance declined by 26% to $6.6 billion in 2013 from the record high of the previous year.  Major issuers during the year were City and County of Denver, RTD, Denver Public Schools, and Denver International Airport.  We expect new supply will remain at or below current levels as the number of refunding issues will decline in the higher rate environment and voters are less enthusiastic about approving new capital projects.

The improving commercial and residential real estate markets have provided a positive impact on property tax collections which is an important revenue source for municipal bond repayment.  This has been especially helpful to elementary school funding which had suffered in the years following the recession.  Sales tax revenues have surpassed the pre-recession highs at the state level and capital gains taxes have provided a significant boost to State coffers.  Overall, the credit quality of investment grade municipal bonds has improved in the past year.

The Aquila Tax-Free Fund of Colorado will maintain its defensive posture by focusing on high quality, intermediate maturity bonds.  Through our emphasis on local research and our disciplined investment approach we strive to provide reduced volatility and double tax-exempt income for our shareholders.

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.