Municipal bonds are only a small part of the broad fixed-income market, standing at roughly $4 trillion in assets relative to the $53 trillion in total U.S. fixed-income assets. However, this asset class can offer some unique advantages to other parts of the bond market that we feel are often overlooked by investors.
In our global market outlook, Market Intelligence, our network of asset managers and research firms views municipal bonds as an attractive opportunity for portfolios with a slightly bullish view. With many issuers having improved their fiscal positions over the past several years, we agree that municipals can offer attractive income on an absolute and tax-adjusted basis while maintaining a high level of credit quality—a combination we believe positions munis to perform relatively well in the later parts of the economic cycle.
Municipal bonds generally offer high credit quality
Municipal bonds, like other areas of the fixed-income market, are assigned credit ratings to help investors assess the creditworthiness of the issuer. According to Barclays data, the Bloomberg Municipal Bond Index offers an average credit quality rating of AA.1 This puts municipals slightly below the average credit quality rating of U.S. Treasury bonds and mortgage-backed securities, which are rated AAA, but above investment-grade corporate bonds that average BBB.
In our view, municipal bond credit quality appears to have improved through the pandemic, based on increased federal aid and higher state and local tax revenues. While there are varying degrees of credit in the municipal bond market, we believe the single A rating part of the market offers sufficient high quality balanced with attractive relative yields.
Given our view that we’re in a late-cycle economy, we believe that striking such a balance is a tactic worth considering. Traditionally higher credit quality bonds have higher levels of liquidity and lower default risk in times of economic stress. In our view, staying above single A in credit quality can limit credit risk while still offering an attractive income stream.
Attractive tax-equivalent yields
Aggressive tightening by the U.S. Federal Reserve (Fed) has led to a sharp upward readjustment of yields, which have reached their highest level in nearly 14 years. The Bloomberg Municipal Bond Index is now offering an overall yield of 4.18%, a level that hasn’t been seen since the midst of the financial crisis in March 2009. Within the index, investors can capture very compelling yields without reaching below investment grade; in fact, BBB-rated bonds are offering a yield of 5.13% while A-rated bonds are offering a yield of 4.58%.2 These yields haven’t been available for investors in years and, in our view, they offer an attractive income stream with limited credit risk.
For another perspective, municipal investors should also look at munis’ yield on a tax-equivalent basis. The tax-equivalent yield is the income that a taxable bond would need to provide to equal the yield on a comparable tax-exempt municipal bond. In using the top federal tax rate of 37%, not including potential state tax reductions, BBB municipal bonds have a tax-equivalent yield of 8.14%, single A municipals 7.23%, and the overall municipal national index offers 6.63%. These yields are at the same level as BB high-yield corporate bonds, but, again, offer much higher credit quality.
Why focusing on quality may be important
As we mentioned earlier, our view is that we’re in a late-cycle economic environment based on several inputs, including The Conference Board Leading Economic Indicators (LEI) and the shape of the U.S. Treasury yield curve. In September, the LEI went negative on a year-over-year basis for the third consecutive month.3 Meanwhile, the Treasury yield curve has been inverted since July (comparing 2- and 10-year Treasuries) while yield on the 3-month Treasury bill exceeded that of 10-year Treasuries in November.4 An inverted yield curve has historically been a reliable harbinger of a recession.
When looking back to past cycles, when the LEI has gone negative and the yield curve has inverted, it’s usually a sure sign of a late-cycle environment. Historically in these periods from yield curve inversions through recessions, we’ve found that higher-quality, intermediate-term bonds have held up better than lower-quality parts of the bond market.
While 2020 was a uniquely challenging environment for municipal bonds due to the pandemic, we now see them as better capitalized and well positioned for a traditional recession resulting from an economic slowdown. Given their high credit quality, attractive level of yield, and history of doing better in late-cycle environments, we believe that municipals offer an attractive opportunity for investors today.
1 Barclays Live, 11/4/22. 2 FactSet, 11/4/22. 3 The Conference Board, 11/1/22. 4 FactSet, 11/1/22.
The Bloomberg Municipal Bond Index tracks the performance of the U.S. investment-grade tax-exempt bond market. It is not possible to invest directly in an index.
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Yield to worst is the lowest potential yield calculated by taking into account an issue’s optionality, such as prepayments or calls.
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