After suffering losses all year, municipal bonds are rallying. Here’s why, and where attractive after-tax returns may be found.

This year is shaping up to be the roughest on record for municipal bonds, with investors nursing more than 11% losses by mid-November, its worst showing in 40 years.The Federal Reserve’s aggressive rate hikes ignited a record $113 billion exodus from municipal bond mutual funds,reversing 2021’s $101 billion record inflows.

 

But the flipside of plunging prices is yields that are too good to ignore, and investors are noticing. After climbing for months, municipal bond yields fell in mid-November, as part of a general rally in bonds after inflation cooled in October and as demand for attractive yields picked up.

 

“What we are experiencing today is the silver lining of this year’s bond rout,” says John Flahive, head of fixed income at BNY Mellon Wealth Management. “Even though yields have come down from their highs we still see investment opportunities for investors in top tax brackets.”

 

Interest earned on munis is free from federal taxes and may also be exempt from state and local taxes, depending on where you live.  Muni yields are typically compared with other fixed income investments on a “tax equivalent” basis – which is the yield a taxable bond would need to equal the yield on a comparable tax-exempt municipal bond.

 

The yield on a Triple-A rated 10-year municipal bond was around 3.14% in mid-November,compared with 1.2% a year ago and offers a tax-equivalent yield of around 5.2% for a person taxed at the effective top federal rate (including the Medicare surcharge) of 40%.4 Investors willing to take on slightly more risk but still stay in high quality investments can receive tax equivalent yields of 5.7% and 6.4% respectively for high quality Double-A rated 10- and 15-year munis, and around 6-7% for the same maturities in the Single-A category. The after-tax benefits are even greater for individuals in high tax states like New York and California.

 

 

Exhibit 1: Higher Yields Make Muni Bonds Attractive

 

A Better Buffer

 

Higher yields are a game-changer for the entire fixed income asset class. For the first time in several years, increased income from higher coupons helps high quality fixed income play its traditional role as a buffer against equity losses in a portfolio.

 

“What has clearly changed is that TINA is over,” says Flahive, referring to “There Is No Alternative” to equities, the market mantra that defined the post-financial crisis period of ultra-low yields and ample liquidity. “Fixed income has become a much more viable solution to meet clients’ long-term goals, now that yields are higher than the S&P 500’s dividend yield.”

 

Flahive moved intermediate Treasury notes from underweight to neutral in balanced portfolios in September and has recommended clients in short-dated munis shift a portion of their holdings to the intermediate part of the curve, to lock in high after-tax yields for a longer period.

 

For those already invested in intermediate municipals and willing to embrace more risk, Flahive suggests strategies that seek out price dislocations across attractive sectors like healthcare and airports. Investors may also want to consider higher yielding bonds rated lower than Triple-A, but still categorized as investment grade. 

 

Resilience In Recession

 

Higher yields usually signal deteriorating credit fundamentals, but that’s not the case in the municipal market today, where yields have risen mostly because of panic selling and seasonal tax-loss harvesting pressures.

 

The market’s default rate has historically been negligible. From 1970-2020, the total cumulative average 10-year default rate across rating categories has been 0.2%, compared with a cumulative average 10-year default rate of 10.6% for all rated corporates.5

 

Strong fundamentals also bolster the municipal market’s resilience to a potential recession in the year ahead. State and local government reserves are flush with cash from federal aid during the pandemic, as well as record tax revenue in 2021. According to a survey by the National Association of State Budget Officers, 49 states reported general fund revenue collections had exceeded original budget forecasts for fiscal 2022. Rainy day fund balances also continued to grow in fiscal 2022, after increasing 62% in 2021.6

 

Despite the recent rally in yields, Flahive believes the fourth quarter is still an attractive entry point, given retail investors may still be looking to sell municipal holdings as part of their year-end tax loss harvesting goals. Rate volatility is also likely to continue until there is more certainty around how high the Fed will hike rates, and to what extent it's willing to weaken the U.S. economy.

 

It might feel counterintuitive to wade into a market that has suffered its worst losses in 40 years, and when the economic outlook is so murky. Yet, intermediate-maturity municipal bonds currently offer the opportunity to lock in an attractive stream of tax-exempt income for at least the next decade.

 

“At these yields, longer-dated municipal bonds can potentially give you a lot of extra income as well as tax efficiency for years to come,” says Flahive.  “And if you stay the course, you will also have the potential to get price appreciation when the Fed takes foot off the brake and yields come back down again.”

 

 

Footnotes

 

As of Nov. 10, 2022. The worst performance since the 1981 inception of the  Bloomberg Municipal Bond Index.

As of Nov. 10, 2022.

S&P Intermediate Municipal Bond Index, Nov. 10, 2022.

4 Tax equivalent yield assumes a 37% federal income tax rate plus an additional 3.8% net investment income tax. For illustrative purposes only.

LORDABBET.COM: “Moody’s U.S. Municipal Bond Defaults and Recoveries, 1970–2020,” published July 2021.

National Association of State Budget Officers, fiscal survey results, spring 2022 edition.

 

 

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