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By Christine Benz and Rachel Barkley | 12-11-2012 02:00 PM

Four Key Areas for Assessing Municipal Health

Pensions and other post-retirement benefits will continue to be a growing concern for municipal governments and muni investors for years to come, says Morningstar municipal credit analyst Rachel Barkley.

Christine Benz: Hi, I'm Christine Benz for Morningstar.

Municipal bonds could be attractive in a higher tax landscape, but investors still need to stay attuned to the risks of the asset class.

Joining me to discuss the muni landscape is Rachel Barkley. She is a municipal credit analyst for Morningstar.

Rachel, thank you so much for being here.

Rachel Barkley: Thank you for having me.

Benz: One thing we've been hearing in advance of the fiscal cliff is that if tax rates do go higher, that could stoke demand for munis. What do you think is the likelihood of that happening?

Barkley: On the surface it make senses that if tax rates go up, you would see municipal bonds become more attractive to investors. Historically, though, we haven't seen that pan out. Looking over the past 20 years, there hasn't been a significant correlation between the relative value of municipal bonds compared to that of Treasuries. Going over the past 20 or so years, we've seen a series of tax increases and decreases, and it hasn't played out in either case.

In the Clinton administration, we saw an era of increasing tax rates, sort of similar to what you may be expecting today if tax rates were to go up next year. And it didn't have a measureable impact on the relative value of munis. On the other hand, with the tax decreases that took place in the Bush era, we also didn't see a measurable impact on the municipal market. On the whole, I'd say that past behavior doesn't necessarily have much to do with potential future behavior.

We would say that there are other factors influencing the municipal market besides the marginal tax rate--from the nominal interest rate to economic events. So, it's really a guessing game.

Benz: So, in the case of the Clinton tax hikes, for example, there was the big dotcom bubble going on, where investors didn't have a lot of interest in bonds, so a lot of moving parts.

Barkley: Exactly, a lot of moving parts.

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