By Timothy Strauts

Municipal bonds had another good year in 2012 as interest rates continued to fall and, despite making a number of high profile headlines, municipal bankruptcies were contained. With interest rates on municipal bonds at 45-year lows, what can investors expect in 2013?

Fiscal Cliff
The "Fiscal Cliff" compromise answered the question as to whether interest on municipal bonds would be taxed in 2013. Municipal bonds avoided all the various proposals to eliminate or reduce their tax exemption. In fact, the increase in the top income tax rate to 39.6% from 35.0% may make tax-free municipals more attractive for some high income investors. After a sell-off in December the municipal market has rallied as investors have shaken off concerns about potential changes to muni bonds' tax treatment in the near term. But the tax status of municipal bonds is far from resolved in Congress.

Credit Quality

We noted the pullback in financial default risk a couple of weeks ago, even in the face of a declining stock market. It's been awhile since we looked at state default risk, so below we highlight charts of 5-year CDS (credit default swaps) for four key states that saw default risk spike significantly in recent years -- New York, New Jersey, California and Illinois.

As shown, default risk for all four states has been trending lower all year, even when the stock market

A confluence of bullish and bearish factors leads to the conclusion that municipal market price activity will remain relatively subdued for the summer, with yields likely to be range bound. However seasonal factors could play a positive role. For instance, muni bond issuance tends to decline in the summer. Since 2000, the months of July, August and September have averaged approximately $28 billion, $29 billion and $26 billion in new-issue supply, respectively. In contrast, the post-2000 average for April through June is more than $34 billion, and for the October-through-December period it's nearly $33 billion. In terms of demand, June and July are among the busiest months for bond redemptions on the muni calendar. As a result, many investors will have additional cash positioned for deployment.

Municipals have underperformed the broader US Treasury market, in part because munis do not benefit from the same global flight-to-quality flows that Treasuries do.