Market dislocations have created a compelling opportunity today in municipal bonds for long-term investors. Yields on high-quality credits have been at the highest levels in at least five years and market fundamentals are very strong. Thus, we are confident that a few years from now, investors will look back at current conditions a once-in-a-decade opportunity.
The current dislocations occurred this year as interest rates climbed from all-time lows and led to record industry outflows. Lipper estimates about $100 billion left the municipal market over 41 weeks in 2022. Investors eager to sell have not differentiated among bonds on the basis of credit quality, sector or tenor. As a result, we believe that investors should focus on higher-quality investment grade-bonds, those rated A, AA and AAA. Both general obligation state and local bonds and bonds that fund essential services such as water, sewer, transportation and electricity generally offer resilient fundamentals and attractive yields, in our view.
Credit fundamentals are strong because tax revenues have rebounded from 2020 Covid lows, allowing municipal issuers to refill rainy day funds and liquidity funds. They generally tap these facilities to make up for revenue shortfalls when the economy slows, which helps them maintain high debt-service coverage ratios. Standard & Poor’s and Moody’s Investors Services have reported four times as many credit upgrades as downgrades year to date.
Municipal bond yields are attractive on both an absolute and a tax-equivalent basis. They are higher now than Treasury yields on bonds of comparable maturity, which is rarely the case. Usually, municipal bonds yield less than Treasuries, because U.S. investors don’t pay income tax on municipal bond income. In today’s market, U.S. income taxpayers are, in essence, getting the tax exemption for municipal bond income for “free,” while investors not subject to U.S. taxes don’t have to give up income to tap the market.
Furthermore, the U.S. income tax cuts passed in 2018 expire in 2025. Barring new legislation, income taxes will rise, making the tax-exempt status of municipal bond income even more valuable and potentially supporting municipal bond prices.
With rising interest rates sparking fears of a recession, municipal bonds also look attractive versus comparable corporate bonds. Municipals are often viewed as a late-cycle asset class because the revenue streams backing the bond payments are less sensitive to the economic cycle than the revenues streams supporting investment-grade corporate bonds, which tend to rise and fall with the US economy.
Of course, interest rates could continue to rise in the months ahead, creating some near-term risk. While we can’t predict precisely when the Fed will stop hiking interest rates, futures market pricing suggests the rate-hike cycle is closer to its end than its beginning. Furthermore, many rate hikes are already reflected in Treasury and municipal bond yields, giving us comfort that yields are close to their peak. Finally, we believe industry outflows are slowing. If so, the market should stabilize, and Treasury and municipal bond yields should revert to their historical relationship, which would be good for municipal bond prices.
All-in-all, now appears to be a very good time to consider initiating a position in municipal bonds or to bring an underweight in bonds back to target. Dollar-cost averaging can reduce the risk of buying too soon--or too late.
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