Municipal Bonds Show Strong Performance Despite Rising Rates
Municipal bonds continue to show strong performance despite rising rates. The tax-exempt yield of munis has increased to the highest level in more than a decade. Many munis are federally tax-exempt, and some are also free of state and local taxes. This may benefit investors in higher tax brackets as it can enhance the income they receive from the bond.
Tax-Exempt
Tax-exempt bonds offer a wide range of benefits to investors, including the ability to invest in low-risk, high-return investments that are generally free of federal income taxes. They also provide a way to avoid paying state income taxes or capital gains tax on dividends earned from investing in these bonds.
Despite recent rising rates, municipal bonds have shown strong performance over the past year. This is because they are relatively safe and can also help protect against inflation.
Investors can buy municipal bonds in a variety of ways, such as through a bond mutual fund or ETF (exchange-traded fund), or through a bank or online brokerage account. In addition, many funds offer a range of maturities and quality levels to meet the needs of investors.
Tax-exempt bonds play an important role in financing a broad spectrum of government projects, from schools and hospitals to water and sewer facilities and public power utilities. But one major change in the 2017 Tax Cuts and Jobs Act eliminated a key tax exemption feature, advance refunding, that allowed issuers to refinance their debt when interest rates dropped.
High-Yield
High-yield municipal bonds offer a compelling risk/return opportunity for investors seeking tax-exempt income that’s often less volatile than Treasury bonds. With the Federal Reserve on a tightening trajectory, it’s a good time to consider adding to your fixed-income portfolio.
The municipal bond market has been resilient, with strong returns this year despite accelerating fund outflows. It has historically regained momentum the year after a negative year, and this year’s 4.1% rally suggests it may be on track for another strong performance.
While interest rate volatility will continue, municipals should provide attractive returns this year. Compared to other fixed-income sectors, their yields are quite reasonable, and with the Fed expected to continue raising rates, they’ll likely have an advantage over Treasury bonds in 2023. In addition, the current low supply of munis and strong credit fundamentals should continue to support municipal prices and yields.
Long-Term
Muni bonds have shown strong performance despite rising rates, illustrating why tax-aware investors are turning to them in their long-term portfolios. With historically low default rates, munis are also safe investments that should offer a good chance for positive returns in the years ahead.
They’re rated AAA, AA, or A by credit rating agencies (see Exhibit 1). These ratings reflect the issuer’s financial strength.
Demand for municipal bonds remains robust as federal stimulus permeates the economy, boosting revenues and liquidity. A lack of new issue supply also supports demand.
Nevertheless, higher interest rates are still a concern. Investors should consider adding alternative vehicles that help offset losses, such as Consumer Price Index swaps. Additionally, a well-diversified muni portfolio should include opportunities in midgrade and high-yield credits that may offer additional income potential.
Diversification
Diversification is the process of spreading your money across different types of investments. This helps to reduce risk and increase the likelihood that you will be able to ride out the ups and downs of your portfolio.
The most diversified portfolio is one that includes different asset classes, such as equities, fixed income, commodities, and cash. This can also help mitigate the risks of a recession.
In addition, diversification can also help protect your wealth if you lose one investment in your portfolio. For example, if you invest 100% in stocks and then the stock market crashes, your entire portfolio will suffer losses.
Despite the recent rise in interest rates, municipal bonds have shown strong performance and continue to offer compelling relative value. Municipal yields have risen less frequently and are smaller than those of taxable bonds, while they feature low correlations to other asset classes.