The municipal bond (muni) market has a market capitalization of nearly $4 trillion1. What are some of the structural nuances that set munis apart from other fixed income instruments?
The key difference between munis and other fixed income asset classes is their tax-exempt status. The interest component of a municipal bond is exempt from federal income taxes, which is a great incentive for states, local governments and other taxing districts to borrow at lower interest rates in comparison to other taxable debt instruments. Some states – including Kansas and Missouri – also exempt the interest for issuing entities within those states, making munis an appealing investment option.
Nonprofit organizations, foundations and private-sector corporations also can issue municipal debt provided the entity uses the proceeds from the debt in a way that benefits the public at large.
Like most fixed income asset classes, munis underperformed during the year. What might investors expect to happen going forward?
Several factors attributed to the pronounced selloff in the bond market this year, none greater than inflation surging to the highest levels in 40 years. Behind this inflationary curve there was uncertainty over how aggressive the monetary response from the Federal Reserve (Fed) would need to be to curb spiking inflation while avoiding any missteps that could hinder economic growth. These headwinds supercharged volatility for munis and the bond market in general.
After experiencing significant outflows in the first half of 2022, conditions began to stabilize. The significant increase in yields across all fixed income investments has provided some opportunity for investors, particularly for munis.
You mentioned we’re seeing slower economic growth. How is the muni market positioned to perform in an evolving market environment?
Obviously, there are concerns about the slowdown in economic growth and the increasing possibility of a recession occurring in the next 12-24 months. As market conditions tighten and economic growth slows, we favor higher quality issues in stable sectors such as fully tax-backed general obligation bonds, water and sewer, as well as transportation-related revenue bonds. We also look for opportunities of geographical diversification in states with heavy issuance like Texas, Pennsylvania, and Illinois.
Historically, muni bonds have had a low rate of defaults. From 1970 to 2021 – a period that experienced seven U.S. recessions – the muni default rates were significantly lower than corporate bonds of the same quality2. For example, the cumulative 10-year average default rate for A-rated munis was 0.10% in comparison to A-rated corporate bonds’ default rate, which was 1.96%.
Are municipal bonds attractive relative to other asset classes and how do they fit into a balanced portfolio?
Several trends are contributing to a compelling backdrop for the muni market. First, the asset class currently looks strong from a credit standpoint. Many state and local municipalities benefitted from strong balance sheet management during the pandemic and have fortified “rainy day funds” from federal stimulus and higher-than-expected tax revenues. The employment picture also remains robust despite slowing economic activity. In addition, the muni market could benefit as Infrastructure Investments and Jobs Act projects ramp up over the next several years.
Another way to view munis in this market environment is on a relative value basis. Investors should look at the taxable equivalent of yields, or the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. When we compare the tax-equivalent yield across several fixed income asset classes, the tax-free income munis offer makes a compelling argument for likely investors.
Lastly, munis may represent a compelling hedge to equity risk in balance portfolios. Not only are munis less correlated to U.S. equity markets, they also often exhibit less volatility.
1 Municipal Securities Rulemaking Board, “Muni Facts,” 2021. 2Moody’s, “U.S. Municipal Bond Defaults and Recoveries, 1970–2021,” April 2022. The Chartered Financial Analyst®(CFA®) Charter is a designation granted by CFA Institute to individuals who have satisfied certain requirements, including completion of the CFA Program and required years of acceptable work experience. Registered marks are the property of CFA Institute. Commerce does not provide tax advice or legal advice to customers. While we may provide information or express general opinions from time to time, such information or opinions are not offered as professional tax or legal advice. Consult a tax specialist regarding tax implications related to any product and specific financial situation. This material is intended to provide general information only, may be of value to the reader and audience, and is reflective of the opinions of Commerce Trust. Commerce Trust is a division of Commerce Bank. Securities and Advisory services provided through Commerce Brokerage Services, Inc., member FINRA, SIPC, and a registered investment advisor. Insurance products are offered through Commerce Insurance Services, Inc. Both entities are subsidiaries of Commerce Bank. This material is not a recommendation of any particular security, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. The information in this commentary should not be construed as an individual recommendation of any kind. Strategies discussed here in a general manner may not be appropriate for everyone. Diversification does not guarantee a profit or protect against all risk. Past performance is no guarantee of future results, and the opinions and other information in the investment commentary are as of October 27, 2022. Commerce does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product or specific financial situation. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed, and is subject to change rapidly as additional information regarding global conditions may change. All expressions of opinion are subject to change without notice depending upon worldwide market, economic or political conditions. Securities and Advisory services provided through Commerce Brokerage Services, Inc., member FINRA, SIPC, and a registered investment advisor. Insurance products are offered through Commerce Insurance Services, Inc. Both entities are subsidiaries of Commerce Bank. Not FDIC Insured | May Lose Value | Not Bank Guaranteed | Not Insured by Any Federal Government Agency