Municipal Bonds: Should You Invest In Munis? – Investors may have bailed on municipal bond funds in record numbers last year, but now the asset class not only looks attractive thanks to high yields, but also appears to be well-positioned to ride out a recession.
As with the rest of the bond market, yields on municipal bonds are at their highest levels in many years. The average municipal bond fund is at 3%, compared to about 1% just a year ago. When investors factor in the tax-exempt nature of many municipal bonds, the yield advantage is even greater, in some cases exceeding those found in comparable taxable bond funds.
Municipal Bonds: Should You Invest In Munis?
In addition, thanks to the general trend of many state and local governments to strengthen their fiscal positions in recent years, credit quality in the muni market is seen as exceptionally strong. That should help muni-bond funds weather the kind of downturn that could hurt corporate bonds or other credit-sensitive parts of the fixed-income market.
Are Municipal Bonds An Attractive Option For Income Investors?
Like many corners of the investing world, municipal bond funds took a hit in 2022 as the Federal Reserve aggressively raised interest rates, leading to big declines in bond prices. For many parts of the bond market, it was the worst year in modern history.
“The Federal Reserve’s rate hike cycle has been a primary factor that has hurt municipal bond yields,” says Nathan Will, Vanguard’s head of municipal credit research.
However, compared to other types of bond funds, muni bonds have held up relatively well. The municipal bond index declined 7.2% while the US core bond index fell 13%.
Among individual funds, the largest municipal bond fund, the actively managed $68.9 billion Vanguard VWIUX intermediate-term tax-free, posted a loss of 6.83%, and the largest index bond fund, $32.2 billion. %. Meanwhile, the $240 billion Vanguard Total Bond Market VTBNX, which invests in U.S. government bonds and corporate bonds, lost 13.1% and the $21.5 billion iShares US Treasury Bond ETF GOVT declined 12, 7% in the year.
How Good An Investment Are Municipal Bonds?
While losses were not as extreme for municipal bond funds compared to taxable bond funds, investment outflows from the municipal bond category were significant.
Investors fled the category, resulting in net outflows of $115 billion, equivalent to 11.5% of all money in municipal bond funds in early 2022. “It was the longest and deepest outflow cycle registered,” says Will.
Those outflows added to losses in the muni market as fund managers were forced to sell bonds to raise cash to meet investor repayments.
The positive side of the sale is that for investors looking to put their money to work, yields are much more attractive in municipal bond funds. That’s especially the case when you consider the main benefit that comes from tax-exempt municipal bond funds: They’re exempt from federal income taxes. Investors can also avoid paying state taxes on the income they receive if they buy municipal bonds in the state they live in, making them even more attractive than taxable bonds.
What Are Municipal Bonds And How Are They Used?
The National Mid-Term Municipal Bond Fund offered an SEC yield of 3% as of Jan. 31. For investors who are married filing 2022 and filing jointly and in the 24% tax bracket (those whose taxable income is between $178.51 and $340.100) that equals a return of nearly 4% of a taxable bond fund.
For investors who fall in the top 37% tax bracket, that equates to a 4.8% return on a taxable bond fund.
Compared to U.S. Treasury yields, muni bonds are offering higher-than-usual yields, managers say. “Long-term valuations are more attractive relative to Treasury bonanzas,” says John Miller, head of municipals at Nuveen.
Factors like the exodus of investors from municipal bond funds last year “do not detract from the strong fundamentals of municipal bonds,” Miller says.
Municipal Bonds (munis)
The fiscal history at the state and local government level is particularly strong at this time. According to Will, cities and states, the main issuers of municipal bonds, are cash-strapped thanks to federal COVID-19 stimulus money. State tax revenues have remained high, and high property values will provide cash flow to cities, keeping them well-positioned to repay bondholders.
Fund managers note that there have been no major write-downs or defaults recently, and in fact, some long-time dodgy municipal bond issuers, such as Chicago, have seen improvements. Chicago also recently issued a “social bond” that is available to smaller investors to finance local projects.
Strong fundamentals and high credit quality become especially important if the U.S. enters a recession, which could squeeze city and state revenues, but its large rainy day funds should provide a cushion. “If the U.S. goes into a mild recession, municipal bonds can be very resilient,” says Nuveen’s Miller.
Fed policy is a risk to munis, as it is to the rest of the bond market. However, managers say future interest rate hikes are already priced into short-term municipal bonds.
Municipal Bonds: Should You Invest In Munis?
This year, as investors weighed new economic data and how much more the Fed will raise rates, bonds have bounced back. The U.S. core bond index advanced 2.3% while the municipal bond index rose 2.5%.
Groups municipal bond funds according to their maturity and based on whether they have a state or national focus. Many investors choose to own individual municipal bonds or create a bond ladder, but municipal bond mutual funds and exchange-traded funds provide diversification and exposure to a wide range of issuers.
Unlike many other types of bond funds, there are not many index-tracking ammunition bond funds. But Thomas Murphy, manager research analyst at , says that active management in the municipal bond market can be an advantage. The municipal bond market is less liquid than many parts of the taxable bond market, and active managers can help navigate the more opaque market, he says.
Among actively managed offerings, for investors looking to limit interest rate risk, the $19.5 billion Vanguard Short-Term Tax-Exempt VWSUX (with a gold analyst rating) has one of the shortest durations. Duration measures the sensitivity of bonds to interest rates and was especially relevant last year as sharp increases in interest rates were the main reason bonds experienced such severe losses. This Vanguard fund has lost just 0.73% in 2022 and is up 0.75% in 2023 as of January 31.
Municipal Market Commentary
Long-term municipal bond funds have posted bigger gains this year as good news on inflation has led investors to believe the Fed won’t need to raise interest rates as much as previously expected. The $2.9 billion gold-rated Fidelity Tax Free Bond FTABX rose 3.5% as of Jan. 31. “The strategy’s higher quality rate and safety selection drove selling results,” writes associate director Beth Foos.
For indexing investors, the VTEB $25.3 Billion Tax-Exempt Bond Index is Gold-rated and priced the lowest in its class. “This fund offers broad exposure to investment-grade, tax-exempt muni bonds. The fund is tilted toward the most liquid and high-quality securities in this under-traded market,” writes analyst Lan Anh Tran.
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The Basics Of Municipal Bonds
To further protect the integrity of our editorial content, we maintain a strict separation between our sales teams and authors to remove any pressure or influence on our analysis and research. Municipal bonds (or “munis”) are issues of debt by city, county, and state government entities to finance capital projects such as universities, hospitals, and infrastructure (e.g., highways, roads, sewers).
Municipal bonds can be thought of as loans to local, provincial, or state governments to finance public projects such as parks, libraries, public transportation (eg, highways, bridges, roads), and other related infrastructure.
The maturity date of a municipal bond usually ranges from one to three years, but there are long-term issues with maturity dates lasting more than one