The Municipal Bond Market Outlook

The municipal bond market is once again offering investors the diversification and income potential they traditionally covet, even in this era of rate volatility. Tax-free yields are attainable, credit quality remains strong and new issue supply continues to decline.

Lower issuance coupled with increasing demand should support attractively valued municipal bonds in 2023. This is particularly true for muni bonds that offer intermediate- and long-term income.

Tax-Free Yields

Municipal bonds, also called munis, are an attractive option for investors seeking a reliable income stream. They’re exempt from federal and state income taxes, and they generally have low default rates compared to other types of fixed-income investments.

However, be sure to consider the tax implications before you make a decision on whether or not to buy a muni bond. For example, some munis are subject to the alternative minimum tax (AMT), so their interest may be taxable for people in AMT-phased-out tax brackets.

Another consideration is interest rate risk, which is the likelihood that a bond will lose value when interest rates rise. That’s why muni bonds have been struggling this year as bond prices decline and rates rise.

In addition to reducing tax liabilities, a high-quality municipal bond should produce a better real return than a comparable taxable bond. That’s why you should use the tax-equivalent yield formula to compare the return on a muni with a taxable bond. It’s a simple formula: Tax-Free Yield / (1 – Tax Rate).

Credit Conditions

The municipal bond market has been under pressure lately as investors have sold bonds they had in their portfolios and stopped buying new issues. This is a common phenomenon economists call “flight to safety.”

Investors typically sell risky assets and buy safe ones when uncertainty is high. State and local government debt is considered extremely safe.

Historically, state and local governments have had the best credit conditions for many years. Their rainy day funds – the funds they use to pay interest on their bonds when other revenues are down – are at record highs.

Despite the recent pullback, credit conditions in the municipal bond market are still strong. While waves of credit downgrades can occur in challenging economic times, defaults are a very rare event. In fact, cumulative default rates for investment-grade municipal bonds total less than 0.1% over ten years, according to Moody’s data as of December 31, 2021. This means that most portfolios with well diversified holdings should not be significantly impacted by occasional defaults.

Supply

Municipal bonds are a popular asset class among investors seeking income with little risk of losing principal. But as a fixed-income security, munis can also be vulnerable to other factors, such as rising interest rates or liquidity issues.

The municipal market has been plagued with volatility and turmoil this year, as the US Federal Reserve hiked interest rates aggressively, inflation reached historic highs, and economic indicators worsened. And many state and local governments face significant cash crunches, particularly in light of delayed federal tax receipts.

Despite these challenges, municipal balance sheets are strong and rainy day funds have remained at all-time highs. These factors suggest a broad-based repricing in the market that will ultimately lead to a more positive return environment, we believe.

The municipal bond market can provide a good alternative to equities for investors looking to diversify away from riskier assets. Investors are also able to earn attractive tax-equivalent yields and, in some cases, at deeply discounted prices (valuation).

Demand

Demand for muni bonds remains strong. A steady flow into municipal bond funds and a generally flat to negative volume of new issuance have supported a robust muni market (Exhibit 1).

Tax-Free Yields

As we noted in our 2022 Outlook, higher tax-free yields will likely support strong demand for municipal investment vehicles across all asset classes. We expect this to be a theme through 2023, as the Federal Reserve continues to hike interest rates and investors look for ways to reduce their tax burden.

While municipal credit spreads3 widened in sympathy with rate sell-offs, credit quality remains resilient. Moreover, historic levels of revenue collections and rainy day funds have protected muni issuers from default risk in the past. Combined with attractive spreads and sound credit conditions, we see select opportunities for investors to add high yield municipal exposure as a part of their core strategy portfolios.