Wall Street Says the Worst Is Over for Municipal Bonds in 2022

Wall Street says the worst year ever for municipal bonds is over. That means munis have become an ideal haven for investors looking to park money.

The muni market is awash in cash, and revenues are rising. The combination of scarce supply, low rates and tight spreads has made munis one of the strongest markets in history.

Credit Risk

Despite the market selloff, credit risk is a concern for investors in the municipal bond space. This risk is caused by the probability that a borrower will fail to meet their debt obligations.

A high level of credit risk can affect both the lender and the borrower, disrupting cash flows and increasing collection costs. It can also cause a bank to use the additional capital to cover losses, lowering its profit.

This year has been difficult for the municipal bond market, impacted by tax reform and the Federal Reserve’s aggressive rate-hiking campaign. Although we still expect to see significant market volatility, overall performance will slow to a more normalized pace as rates settle near the Fed’s neutral rate of 2.5%.

Municipal bond valuations remain attractive, especially for long-term bonds ten years or more in maturity. Favourable supply and demand technicals should keep muni prices stable. Additionally, we continue to see select opportunities in lower-rated credits as outflow-driven spread widening and a risk-off environment have made some credit valuations more attractive.

Liquidity

The 2022 year has been difficult for fixed income, but Wall Street says that the worst is over. Investors should take advantage of this market opportunity and invest in a diverse municipal bond portfolio to earn attractive yields without worrying about the lingering volatility affecting interest rate markets today.

Credit spreads have widened in sympathy with the rate selloff, but credit quality remains strong. In addition to resiliency to the Fed’s tightening policy, credit conditions continue to benefit from historic levels of revenue collections and rainy day funds.

Despite the recent decline in issuance, this market still has more demand than supply. We are watching for clues to indicate that this dynamic is stabilizing. Reducing taxable muni supply also should help support pricing in this market.

Taxes

Generally, interest from municipal bonds is tax-exempt at the federal level. Depending on your tax bracket, you may also receive a state or local tax deduction when investing in munis.

Alternatively, you may also be subject to state and local taxes on short-term and long-term capital gains realized when selling a bond. This could impact your overall portfolio and tax liability.

The special tax treatment of munis is the primary reason investors invest in them. However, you should always ensure that you understand a particular investment’s tax implications before making a decision.

Municipals face significant risks, including market, interest rate, issuer, credit and inflation. As such, you should only invest in a fixed-income portfolio under the guidance of a qualified advisor.

Defaults

After the worst year-to-date performance of any asset class, many investors are catching on to the fact that municipal debt has much going for it. Tax-free income compensation is at a record high, and credit fundamentals are strong.

However, higher interest rates are a potential hiccup in muni performance. The Federal Reserve recently hiked interest rates by 300 bps, and market participants are expected to hike further.

Investors also are worried about the recent increase in inflation, and if it continues at this pace, several municipal credits could be negatively affected. For example, some bonds backed by per-gallon gas taxes or public transit fares could fall in value as the price of these items rises.

Historically, defaults associated with municipal bonds are very rare. According to Moody’s Investor Service, the default rate has been 0.08% from 1970 through 2020.