Municipal Bond News 9/18/23

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Why Now Is A Great Time To Invest In Muni Bonds

The risk-reward balance has tilted in favor of moving cash from the sidelines to longer term tax-free fixed income investments. Locking in current tax-free yields, the highest this year, fends off cash reinvestment risk. Beneficial tax swaps, that replace a security with an unrealized market loss with a current market security, can be accomplished in the current market environment. At today’s high tax-free yields, upgrading or buying higher rated municipal bonds to reduce overall portfolio risk is favorable for bondholders. Faced with volatile markets, waiting to invest cash until there is more certainty could potentially be a drag on tax-free income and returns. Reliable tax-free coupon income from U.S. government payors is a reprieve from volatile financial markets for those able and willing to hold long term tax-free bonds. Current tax-free yields are high, such that interest payments should be large enough to insulate from potential price losses from policy rate hikes.

While passive investors are assessing if rewards from a muni bond rally could be larger than the risk of losses from additional rate hikes, aggressive investors are buying muni bonds now.

Muni bonds carry a significant yield advantage over similar-rated taxable counterparts, and muni bond valuations are attractive. Tax-free state and local government bonds currently offer perhaps the best opportunity for higher tax -free fixed income in more than sixteen years.

Here are 10 reasons:

U.S. Treasury Rout…The summer selloff in the U.S. Treasury bond market has led to higher yields on state and local government bonds. Muni bond yields have jumped about 30 to 40 basis points over the last month. Currently, top rated long term muni benchmarks yield 3.97%, up 70 basis points from this year’s low hit in April. The surge in muni yields follows a surge in comparable U.S. Treasury bond yields. U.S. Treasury bonds yield 4.38% for 30 years. The bellwether 10-year United States Treasury yield is 4.28%, up from around 1% at the end of 2021. An era of ultra-low rates, which ended last year, allowed for scanty yields, forcing investors to buy riskier securities to meet income goals. Today’s higher tax-free yields are a silver lining for buyers of state and local government bonds.

Are Yields Near Peak…Bellwether yields are near highs in the current interest rate cycle, some experts reckon. Bellwether U.S. Treasury yields have already peaked, nearly 80% of strategists polled by Reuters believe. Their median forecast for the 10-year Treasury note yield is 3.91% by end-November and 3.50% in a year. A strategist told Bloomberg that interest rates have historically peaked about two months prior to the end of a Fed tightening cycle, making the recent increase in yields a potential opportunity.

Muni Bonds’ Relatively Steady In Volatile Markets…The $4 trillion muni market is less volatile than taxable counterparts, such as the U.S. Treasury market. The tax-exemption feature of muni bonds lends stability to municipal yields. Retail investors, the largest holders of muni bonds, favor tax-exempt bonds. Faced with a shortage of tax-free reinvestment opportunities, investors tend to hold muni bonds for steady tax-free income. In contrast, U.S. Treasuries’ largest holders are the U.S. Federal Reserve, Japan and China. U.S. Treasury yields’ volatility feeds from both domestic and geopolitical forces. Muni bonds have generally outperformed taxable Treasury bonds and corporate bonds. Longer-dated state and local government bonds have outperformed with close to 2% index return this year.

Muni Bonds’ Yield Advantage…State and local governments offer a significant yield advantage over similar-rated taxable counterparts. For example, New York City’s recent general obligation bond issue offered a top tax-free yield of 4.35% equivalent to a 6.6% taxable yield for 35% tax bracket investors. That’s 55% higher than comparable U.S. Treasury bonds’ 4.26% yield at the time (August-23). Fueling prospects of rising taxes, investors reckon that taxpayers will ultimately pay for the highest federal borrowing costs in years. It is no surprise that most new muni bonds issued in the primary market are oversubscribed.

More Yield For Longer Dated Munis…Muni bond investors receive higher yield for longer dated muni bonds, relative to shorter maturities, referred to as a traditional yield curve. However, the same is not true for U.S. Treasury bonds, which carry an inverted yield curve. The yield gap between 10-year and 30-year UST is barely 10 basis points. In contrast, the yield gap between 10-year and 30-year Muni bonds is 100 basis points. Fixed income investors receive relatively higher compensation for purchasing muni bonds.

Muni Bonds’ Most Popular For Retail Buyers…Individual investors added to muni bond portfolios in 2023. “The combination of tax-free income and relative safety has made munis the most popular investment for retail buyers,” Barron’s wrote in July 2023. CNBC echoed, “Municipal bonds can offer your portfolio tax-free income and stability as recession fears loom” adding recently, “Municipal bond valuations are attractive right now.” This year, outflows from mutual funds have abated. This year, mutual funds have sold $8 billion of muni bonds through August to meet redemptions, much lower than outflows of about $80 billion at this time last year. Wealthy investors are taking advantage of higher tax-free income from muni bond investments.

Muni Bond Supply Shrinks…States and local governments are issuing muni bonds at the slowest pace since 2019. 2023 supply of muni bonds is about 19% lower than a year ago. In 2022, $390 billion new muni bonds were issued, almost 25% lower than a year ago. A glut of cash, along with high interest rates and volatile markets have led states and locals to avoid new bond sales. Two successive years of sharply declining muni bond sales has left investors scrambling to find tax-free reinvestments for maturing bonds.

State and Local Governments’ Credit Conditions…Since the Great Recession, U.S. state and local government finances have improved steadily. After robust surpluses driven by massive COVID-19 federal aid, state revenue collections are declining. High inflation, high interest rates, financial market volatility, weakening home prices could slow the economy. Equipped with healthy reserves, states and cities are beginning to respond to lower tax collections. Spending cuts in California and New York City are examples. Municipal bond defaults are miniscule relative to corporate bonds. Some municipal bond issuers boast credit ratings higher than U.S. Treasury. Majority of municipal bonds are higher rated.

Fed Committed To Fight Inflation…Headline inflation dropped to a 3.7% annual pace in August from 9% a year ago. High energy prices have contributed to higher-than-expected consumer prices. Core inflation, which strips out volatile food and energy, has moderated to a 4.3% annual pace, down from an earlier 4.7% reading. Consumers expect inflation to ease to a 3.1% over the next year per the University of Michigan. Committed to fighting inflation, the Fed’s aggressive rate hikes are beginning to take effect.

Rate Cuts Likely Next Year…The Fed is likely to keep rates higher for longer. Futures markets anticipate the first rate cut in the middle of next year. Making the case for a ‘soft landing’, a resilient U.S. economy is expected to grow 4.9% in the third quarter of 2023 per Atlanta Fed’s model, down from 5.6% estimated earlier. When Fed policy changes, bond yields are likely to decline. Muni yields are correlated with yields on comparable U.S. Treasury bond yields and fed-funds rate policy. The muni market has gained 1.5% this year, as it struggles to emerge from a 8.5% loss last year, the worst showing in four decades. Historically, muni bonds have showed positive returns when rate hikes ended.

Information obtained from sources deemed reliable; GMS does not purport Review/Preview contains all available information.