Strong Municipal Bonds Rising Rates

Alan Appelbaum

December 8, 2022

Municipal Bonds

Despite the rise in interest rates, municipal bonds have performed quite well over the past few months. They have enjoyed very high yields and are a relatively safe investment, especially if you plan to hold them long-term.

Long-term perspective

The municipal bond market can be volatile whether you’re a new investor or a seasoned veteran. While it may be tempting to steer clear, the long-term perspective can help you stay ahead of the curve.

The municipal bond sector has been a relative standout in the fixed-income arena. This is because of the strong financial position of muni issuers, which means a lower risk of default. Additionally, tax-exempt income can support the price of muni bonds.

Credit fundamentals are improving, which means the yields on high-quality credits are at their highest level in a decade or more. The long-term yield on a 10-year AAA municipal bond doubled from one year ago.

The long-term bond yield is already close to the Federal Reserve’s long-run neutral rate of 2.5%. This has led to a flattening of the yield curve, which signals stabilization. The municipal sector has also received much-needed fiscal stimulus from the federal government.

The American Rescue Plan, for example, has provided $513 billion in funding for school districts, state and local governments, and hospitals. It has also provided funding for transportation, airports, and other public services.

Tax-equivalent yields appear secure and relatively attractive

Despite recent interest rate increases, tax-equivalent municipal bond yields appear secure and relatively attractive. While these are not a direct substitute for a tax-free bond, they may offer a valuable entry point for tax-exempt investors.

The taxable equivalent of a ten-year AA general obligation (GO) muni rate is a 6.13 percent yield, while the tax-equivalent yield on a generic five-year BBB-rated muni is 3.4%. However, if the issuer’s credit quality is adjusted to reflect the current market environment, the taxable equivalent may be higher.

As of March 23, the tax-equivalent yield on ten-year AA GO munis was 208 bps above the comparable Treasury yield. This is a good sign that the Federal Reserve has priced its intentions to raise the federal funds rate.

In addition to the higher federal funds rate, inflation has continued to be a thorn in the federal government’s side. The Fed has signaled its willingness to fight inflation by raising the fed funds rate by 300 bps in 2022.

Resiliency to down-market cycles

During periods of market declines, municipal bonds have been able to demonstrate tremendous resiliency. This has been a result of some factors.

First, credit quality remains strong. This is a key reason to invest in the municipal bond market. Although historical default rates are higher than in pre-pandemic times, they remain low. Also, municipalities are putting more attention on climate resiliency efforts.

Second, supply is falling. This has led to greater demand. In the third quarter, taxable supply decreased by over 15% from the previous year. This was a result of decreased taxable municipal issuance from refunding.

Finally, price valuations are attractive. These are much better than in previous cycles.

As a result, municipal yields have moved higher. This is primarily due to the Federal Reserve’s recent market activity. It is also a function of the economy showing signs of weakness.

Inflation has remained a significant headwind for the muni market. The Federal Reserve has been attempting to contain inflation, raising the federal funds rate by 300 bps.

High yields

Although rates have increased substantially over the past few months, municipal bond yields remain attractive. The spread between taxable and tax-equivalent yields is currently near multiyear lows. This gives individual investors an attractive entry point for muni bonds. However, it is important to keep in mind the risks associated with fixed-income investments. These risks include credit, interest rate, inflation, and liquidity.

During times of market stress, muni bonds may experience heavier losses. However, overall, the financial positions of issuers remain strong. This has helped to lower the likelihood of default. Nevertheless, the economic slowdown could also impact the quality of municipal bonds.

Regardless of the economic outlook, investors should stay focused on their long-term goals. Historically, the quality of municipal bonds has been very high. This results from healthy balance sheets, which have been supported by massive pandemic-era fiscal support. This should keep the lid on spread for some time.

Tax-adjusted municipal bond yields are still attractive for investors in higher tax brackets. The Bloomberg Municipal Bond Index is yielding 4.1% as of October. This compares favorably with the average yield for intermediate-term core bond funds, which is 3.55%.