Fixed income
May 23, 2022
Municipal bonds now feature much improved yields (especially after adjusting for taxes) because of the negative returns they experienced in the first quarter of 2022. These higher yields are available even as creditworthiness for municipal issuers is arguably stronger than it has been in recent years. The risk of price volatility persists, but a cost-averaging buying strategy can help to mitigate this risk.
Municipal bonds suffered a nearly 9% loss from December 31, 2021, through April 30 of this year1, drawing the notice of investors accustomed to a low-volatility tax-exempt bond environment.
But in fixed income, what goes down in price must go up in yield. Nominal municipal bonds featured a yield to maturity of 3.18% as of April 301. That presented attractive valuations both relative to other bond sectors and from a historical perspective. In the past ten years, muni yields have only been higher than 3% two other times, and then quite briefly.
Depending on an investor’s state and federal income tax brackets and the particular investment, the investor’s tax-equivalent municipal yield may be higher than 5%. For investors in higher-tax states like California and New York, taxable-equivalent yields of corresponding state indexes may be north of 6.75%.
Source: Bloomberg indexes, using yield-to-worst data as of April 30, 2022. The municipal tax-equivalent yield is calculated using a 40.8% tax bracket, which includes a 37.0% top federal marginal income tax rate and a 3.8% Net Investment Income Tax to fund Medicare.
Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index
The municipal market, despite its idiosyncratic nature, is much influenced by U.S. Treasury yields. When Federal Reserve officials signaled their commitment to fighting inflation early this year, investors began pricing in some 9 to 11 quarter-point expected interest rate hikes through 2022, which upended the fixed income markets. Municipals were no exception.
Typically, a significant risk-off event is required to reach current yield levels, such as an economic recession. Such conditions threaten downgrades or even defaults. But in today’s environment, municipal credit has been bolstered by federal fiscal stimulus provided directly both to municipalities as well as to end consumers.
State and local income tax revenues have risen at a velocity not seen in 20 years, easing near-term credit concerns. Issuers have used some of the flood of finances to build up their rainy-day funds, which can be a cushion for meeting budgets even during recessionary or otherwise difficult conditions. All of which means that credit conditions are better than they have been in years.
Source: Pew Charitable Trusts, using data from the National Association of State Budget Officers as of December 31, 2021.
Sources: U.S. Bureau of Economic Analysis, as of March 31, 2022.
These arguments for an attractive yield in a healthy market are not meant as a timing signal, since there are risks with all investments.
It is possible that the market will continue to price in more interest rate hikes and that outflows could continue. Either of these potential events could lead to further price drops (and yield increases) in the near future.
However, the bond market has already factored in an aggressive Fed rate-hiking campaign. Should the market decide that enough, or too much, rate-hiking has been priced in, and municipal bond fund net asset values stabilize, then cash flows could moderate or turn positive. This, in turn, may lead prices to rebound.
Investors considering a new allocation to the muni sector, or those hoping for reentry after fleeing earlier this year, might consider a cost-averaging strategy. This would help diversify the risk of coming in too early or too late.
With yields as high as they are, municipal bond funds offer a buffer against yields rising even further. A muni bond fund with a yield of over 3% and a duration2 of 6 years, would still provide a positive return for the next 12 months even if yields were to rise another 50 basis points across the curve.
Despite the risks, the environment for municipal bonds is improving because of attractive yields, strong state and local government financial conditions, as well as last year’s fiscal stimulus by the federal government. Investors interested in tax-free income with relatively low default risk might want to consider adding municipal bonds to their portfolios.
1 Figures as indicated by the Bloomberg Municipal Bond Index.
2 Duration is the weighted average time for an investor to receive coupon interest and principal payments that would potentially allow the investor to recoup the bond’s price from its cash flows.
Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.