With virtually no new issue supply to speak of this holiday week and relative stability on the rate front, this might be a good time to take stock of everything that’s happened in the muni market this year. And there certainly hasn’t been much to be thankful for.

By any measure, this has been a tough year for virtually everyone in the tax-exempt market. After capping two great performance years on an impressive rebound from the 2010 Meredith Whitney debacle, municipals finally ran into a wall this past May along with the rest of the fixed-income markets. The tax-exempt market even underperformed its taxable counterparts, mainly as a result of a couple of idiosyncratic issues: Detroit and Puerto Rico, both landmark credit events in their own rights.

This summer’s debacle once again highlighted a key factor which has been both a blessing and a curse for our market: our dependence on retail investors. While retail buyers normally bring great stability to the market with their buy-and-hold bias, they are also prone to bouts of panic selling in reaction to sensational media headlines.

As the preferred retail investment vehicle, the mutual funds have borne the brunt of the selloff. According to The Bond Buyer, “long-term open-end muni funds have posted negative returns of 4.28% through November 18. That compares to gains of 10.07% in 2012, 8.45% in 2011 and 2.61% in 2010. Over the past two quarters, they’ve fallen 5.00% (…) Long-term closed-end muni funds have lost 6.77% in value through November 18. That compares to positive returns of 16.87% in 2012, 13.97% in 2011 and 3.82% in 2010. The past two quarters alone, they’ve dropped 8.12%.”

As net asset values have tumbled, investors have been deserting the funds in droves. As of the week ended November 13th, according to Reuters, “year-to-date outflows have reached $50.03 billion, the most since at least 1992. The previous annual high for outflows was nearly $15 billion in 1994.”

Of course, some of the wounds our industry has suffered have also been self-inflicted. Arguably, some of the mutual funds’ blatant disregard for portfolio diversification and risk management (e.g. their Puerto Rico exposure) has led to even greater outflows.

The sell side has not been immune from the general retrenchment in munis either. Trading losses over the summer have also been compounded by a continuing decline in new issue supply. Year-to-date through the end of October, new issue volume has declined by 14%, to $276 billion, compared with $319 billion over the comparable period last year. Also on a year-to-date basis, new money issuance did rise by 9%, to almost $128 billion, but not enough to make up for a 31% drop in refundings.

Finally, with Dodd-Frank and the Volker Rule finally reaching the implementation stage, it’s fair to say our industry will be handcuffed as never before from a regulatory standpoint. It’ll be interesting to see how business can get done in this new compliance environment.

So is there anything we should be thankful for, really? It turns out there’s still plenty of room for optimism.

First of all, it shouldn’t come as any great surprise that this year’s setbacks are creating attractive opportunities for next year. In our own marketing literature, we’re using the following slogan: “A market in disarray is a market rife with opportunity,” and we strongly believe that.

This year’s “correction” has turned the U.S. municipal market into one of the best, if not the best, relative values among all global asset classes. With muni ratios ranging from 95% to 115%, depending on where you are on the curve, tax exemption has become both compelling and irrelevant at the same time. US taxpayers will be hard-pressed to find equivalent taxable yields anywhere else on the planet, particularly on a risk-adjusted basis. For the first time ever, crossover investors, even some from overseas, can legitimately consider municipals for their total return potential, without regard to tax exemption.

Although the great secular rate decline of the last two decades may be nearing an end, deflationary forces, both here and overseas, should work to limit and contain any potential rise in rates. Thus, 2014 should be The Year of the Credit Investor, one who can add “alpha” through insightful credit plays.

After an extremely volatile 2013, the Puerto Rico bond complex will remain the single most compelling potential investment opportunity going into 2014. Although the Commonwealth has been able to stop the freefall in its bond prices with a watershed investor call on October 15th, it has only earned itself a temporary reprieve until its economy actually shows signs of turning around. Either way, another bout of volatility cannot be ruled out, particularly around the second quarter of 2014.

Many of the headline muni defaults and bankruptcies are well on their way to getting resolved. We’ve already talked extensively about the Jefferson County saga finally coming to a close. The City of Stockton, California is also poised to exit Chapter 9 in the first quarter of next year, assuming it can placate its last creditor, the Franklin Funds (Franklin is still unhappy, and understandably so, that Calpers didn’t share in the pain of the city’s debt adjustment). And then we have Harrisburg, which went into receivership late in 2011 but never received permission to file Chapter 9. The Pennsylvania capital is hoping to come to market next week to finance the sale of its incinerator to the City of Lancaster, a key step in its financial recovery plan. Last but not least, Detroit’s eligibility to file bankruptcy should be resolved in early December and, assuming the city does qualify, an exit from Chapter 9 within a year would not be out of the question.

Whatever the ultimate outcome of the Detroit situation, one thing is certain: we will get much more clarity about the legal standing of the various classes of muni creditors in Chapter 9, from bondholders to retirees.

Of course, the City of Chicago or the State of Illinois may well end up replacing Detroit in the headlines next year, but we doubt their potential market impact will be quite as significant this time around.

Last but not least, technology still holds the promise of advancing municipal disclosure and price transparency, and it is a topic we will be discussing regularly in this column.

When all is said and done, we’re still glad 2013 is coming to a close, so we can now look forward to starting fresh in the new year. In the meantime, have a warm and joyful Thanksgiving and do go easy on that turkey!

[Note: MuniBond Insights will not be published on Friday 11/29, in observance of that great religious occasion, Black Friday!]

Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.

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