NEW YORK (MainStreet) — As interest rates creep slowly upward, bond investors get increasingly nervous – anxious about the impact of rising rates on fixed income portfolio values. But there is a bond segment to consider in such circumstances: It may be time to go tax free.

Christine Todd, president of Standish Mellon Asset Management says municipal bonds have a yield advantage over Treasuries and are likely to be a fixed income investment that outperforms in 2014.

"Excess yield cushions the impact of gradually rising rates," says Todd, in a municipal bond outlook. "Municipal bonds generally have produced positive total returns, even during periods when the Federal Reserve is tightening monetary policy by raising short-term interest rates."

While munis may offer some resiliency to rates, one risk remains: liquidity. Last year the tax free market suffered substantial redemptions in muni bond mutual funds, triggering forced selling by fund managers. And as financial institutions struggled to comply with new federal regulations, many resisted committing assets to municipal bonds, further reducing the depth of the market's support, the report says.

Still, it's a bit more nuanced.

"Individuals and banks continued to buy municipal bonds during 2013," Todd says. "Individuals and banks historically have demonstrated an appetite for tax-free municipal bonds whenever the yields of these bonds have climbed substantially above the after-tax yield from Treasuries."

New tax free issues have been few and far between over the last three years, but Standish expects to see an increase in municipal bond deals over the long run to feed the need for infrastructure improvements. That would reverse the recent low levels of issuance brought on by austerity programs at the state and local government level. However, Standish expects new issues to support infrastructure will be seen over a longer term, as such programs tend to take several years to complete.

Todd noted that the tax benefits of municipal bonds will continue to appeal to individual investors, especially at tax time.

"As investors begin their 2013 taxes, they are likely to be cognizant of the tax burden on taxable interest income," she says.

However, there continues to be a lack of supply in the tax free market as January issuance of muni bonds continued to lag analyst expectations. Thomson Reuters reports 2014 began with only 587 new issues in January, amounting to $18 billion, down 33% from the period a year ago. January 2013 saw 897 new deals totaling $27 billion.

--Written by Hal M. Bundrick for MainStreet