Municipal-bond week in review: Yields head back up

Municipal bond yields hit another one-year high this week after the Federal Reserve followed through with long-expected plans to raise interest rates.

The 10-year yield on the AP Municipal Bond index was 2.826 percent as of 5 p.m. Eastern Time on Friday. That's just above 2.808 percent two weeks ago. As recently as August, yields were more than a full percentage point lower.

While it had long been expected that the Fed would increase interest rates in December, the change still hammered bonds. On Wednesday, Fed officials said they expected to raise short-term rates three times next year, an increase from previous estimates of two increases.

"The Fed announcement was a little more bearish than people expected, but I don't think that's what people are focused on," says Chris Ryon, a portfolio manager at Thornburg Investment Management. "The main drivers of the market right now are the expectations of (economic) growth and inflation." Bond investors fear inflation, since it lowers the value of a bond's fixed payments.

Long-term 30-year municipal bonds, which stand to lose the most from future rate increases, also saw yields jump. As of 5 p.m. Friday, the 30-year yield on the AP's index was 3.543 percent, up from 3.406 last week.

Because longer-term bonds carry more risk, investors demand a premium to hold them over shorter-term bonds. That gap, or spread, between yields of two-year and 10-year municipal bonds widened this week to 1.435 percent. At the end of last week, it had narrowed to 1.336 percent.

When bond yields rise, prices fall. The largest municipal bond exchange-traded fund, the iShares National Muni Bond ETF, fell 0.6 percent this past week.

--The 2017 outlook for munis: turbulence ahead

It was an unexpectedly challenging year for municipal bond funds, and investors can expect another dose of turbulence in 2017, according to a recent forecast by Barclays. Of particular concern: the prospect of corporate tax reform, which could significantly dampen demand for munis.

"We think that it hardly is a question whether municipal demand is going to be affected; it is to what degree, and much will depend on the extent of corporate and personal income tax cuts implemented by the Trump Administration," wrote report authors Mikhail Foux and Mayur Patel.

On the muni supply side, 2016 was well above average and the highest it's been since 2010. While Barclays expects year-over-year supply to fall 16 percent, that's largely because issuers are less likely to refinance current debt in a rising-rate environment; new supply should still exceed 2016 numbers. Sector-wise, supply is likely to be strong in surface transportation and airports, and less robust in health care, education and utilities.