Building an Inflation Strategy With Munis

The consumer price index rose 5.4% in June 2021, the most significant jump since August 2008, on the eve of the financial crisis. According to a Federal Reserve survey, consumers believe that prices will rise 4.8% over the next 12 months. While professional investors are more inclined to think that inflation will be temporary, some are starting to change their minds.

The recent surge in inflation is stronger and more durable than policymakers initially anticipated, although it remains tame outside of pandemic-related areas like used car prices, airfares, and transportation. For example, used car and truck prices rose 10.5% in May, accounting for one-third of all the month’s consumer price index gains.

Still, even when confined to these areas, rising inflation could negatively impact the cost of living, particularly for retirees on a fixed income. While food inflation should slow next year, the ever-rising cost of housing suggests that some inflation could stick around in some areas for the long term. These dynamics could put pressure on bond yields over time.

Investors that don’t require income from their portfolio may decide to reinvest maturing bonds into stocks to fight inflation. However, those that do may need to look for unique opportunities to hedge against inflation—such as muni bonds. These bonds may offer attractive yields to combat inflation while generating a consistent source of income.

Municipal bonds, or muni bonds, have become a popular alternative to Treasuries amid the threat of higher taxes. President Joe Biden’s proposal to hike the top capital gains tax rate to 39.6% encouraged many high net worth investors to buy muni bonds, which don’t have to pay federal tax on interest and may also bypass state and local taxes.

Over the past year, these dynamics helped muni bonds outperform many other government and corporate bonds, including high-yield categories. General obligation (GO) bonds, in particular, have seen their yields fall sharply lower amid a surge in demand. As a result, it can be challenging for any investor—especially retail —to find opportunities in these areas.

That said, many revenue bonds continue to offer an attractive yield along with the tax advantages of owning a muni bond. Investors seeking these opportunities must look beyond passively-managed funds that are obligated to hold GO bonds and toward actively managed funds that have the flexibility to seek out better opportunities.

Muni bond ladders also enable investors to lock in higher yields with longer-term bonds while using shorter-term bonds to capture higher yields if rates rise without liquidating long-term holdings at a loss. When looking for bonds, investors should be mindful of credit quality (especially with high-yield bonds) and ensure call protection is in place.

Be sure to check our Municipal Bonds Channel to stay up to date with the latest trends in municipal financing.

Inflation continues to rise sharply during the second half of the year, and many investors are concerned about the rising cost of living. While the entire fixed-income sector suffered over the past year, muni bonds have become a safe haven due to their tax-advantaged status and higher yields than Treasury bonds, particularly in the case of revenue bonds.

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