Despite Inflation, Munis Still Have Value

The municipal bond sector is arguably one of the most boring segments of fixed income. There’s a good reason for that. These bonds issued by states and local governments are used to fund day-to-day activities, special projects and other needs. Because they are backed by tax revenue, investors do not really consider them risky. And most munis are considered long bonds, with maturities of a decade or more.

That maturity profile has been a recent problem with inflation and rates rising.

Bonds and interest rates have an inverse relationship. That’s because as rates rise, new bonds entering the market have higher yields. So, investors sell previously issued bonds, with their lower interest rates, to buy new ones. As such, the price of already issued bonds falls. Prices for short-termed bonds don’t fall as much, since they are able to roll over faster than longer-dated ones. However, for munis and their 10-,15-, or 30-year maturity dates, this is a huge issue.

With the Fed ratcheting up rates, munis have fallen by a record of nearly 12% this year, pushing yields up to the highest levels in more than a decade.

With the recent underperformance, investors should not be throwing away their munis. They should be buying them hand-over-fist.

Despite the poor year-to-date returns for the sector, munis actually do well in periods of high inflation. According to investment manager Aberdeen, munis have performed better than many other varieties of debt. Looking at other Fed tightening cycles, Aberdeen’s analysis shows that the ratio of municipal yields versus Treasury yields tends to compress, leading to their outperformance. Meanwhile, when looking at investment grade corporate bonds, munis have outperformed them by an average of 26 basis points during historical inflationary periods.

At the same time, munis have been wonderful places to hide out during post-tightening economic environments, i.e., recessions. Because they are backed by tax revenues and a state or local township can raise taxes to cover their debts, muni’s credit quality tends to hold up better during recessions than corporate bonds. There’s less credit drift with munis. At the same time, default rates are very low. From 1970 to 2020, the average municipal cumulative default rate was just 0.2%. This compares to 8.6% for investment grade corporate bonds during the same period.

Then there are taxes to consider. The hallmark of municipal bonds is that they are free from Federal income taxes and potentially state/local taxes as well. When considering taxes and tax-equivalent yield for munis, they are currently yielding more than corporate bonds. The average intermediate muni fund has a tax equivalent yield of nearly 6% for someone in the highest tax bracket. That is a considerable advantage for the sector.

Even better for municipal bonds is the unknown tax situation. While the midterm elections make a tax hike unlikely in the direct future, the long-term picture remains a bit murky. Right now, munis offer one of the only ways to lock in high tax-free income, especially when proposals to tax capital gains, buybacks and dividends at higher rates have all been floated.

Given the current high yield on munis, their typically inflationary outperformance, recessionary strength as well as their tax advantages, investors should seriously consider them for their portfolios. And there are numerous ways to do just that.

Individually, munis can be hard to buy. Typically, they require large investments, and institutional investors often buy up supplies before they really hit the public markets. To that end, mutual funds and ETFs are the best way to gather exposure. Pretty much every mutual fund company or large ETF sponsor has a muni fund in its roster. The Vanguard Tax-Exempt Bond Index Fund Admiral Shares (VTEAX) and SPDR Nuveen Bloomberg Municipal Bond ETF (TFI) are just two low-cost examples.

Closed-end funds (CEFs). These unique mutual fund/ETF hybrids offer the ability for investors to buy munis at a discount and with higher yields. Because of their structure, CEFs tend to hold more illiquid assets and represent some of the largest owners of municipal bonds. There are numerous CEFs on the market that feature the bond. Here, investors can score tax-free yields in the 6% to 7% range.

Check out this article to see if it makes sense to buy closed-end municipal bond funds.

The recent carnage in municipal bonds makes for a compelling opportunity. Despite inflation risk, the bond sector offers plenty of inflation-fighting ability, high yields and future-proof tax avoidance. For investors, adding a dose of munis makes a ton of sense in the current market.

Sign up for our free newsletter to get the latest news on municipal bonds delivered to your inbox.