We think current conditions provide opportunities in municipal bonds that fit well within a broad portfolio allocation.
For our continuing Investment Ideas series, we discussed the complexity of investing in the US municipal bond market with two of our leading professionals in this space: Jennifer Johnston, Director of Municipal Bond Research at Franklin Templeton Fixed Income, and Barbara Ferguson, Portfolio Manager for Municipal Bond Strategies at Western Asset Management.
Here are my key takeaways from the discussion:
- Municipal bonds have attractive, unique characteristics to consider today.
- Relative to other fixed income asset classes, municipal bonds offer higher average credit quality with lower average default rates.
- Supply and demand drive opportunities, and there is currently a shortage of municipal bond supply. On the supply side, issuance of new bonds has been lower as state and local budgets are in better shape following the pandemic and municipalities need less financing capital. In contrast, issuance of US Treasuries and corporate debt has increased dramatically. Along with a smaller supply of munis, demand is rising.
- Municipal bonds tend to trade less efficiently than other fixed income instruments. We believe professional managers are best equipped to identify and take advantage of investment opportunities stemming from these market inefficiencies.
- Specific to cash or money market holdings, municipal bonds offer attractive opportunities.
- Our panel cautioned that an investor could miss opportunities in municipal bonds by waiting to invest. Currently, the municipal bond yield curve is inverted. As it corrects, there will be a race to invest, but many opportunities will be gone by then. We believe investors should consider “putting a toe in the water” with the addition of munis to their portfolios.
- Reserves built up in state and local government rainy day funds during the pandemic (due to greater Federal grant money and lower expenditures on government services) should help them weather economic downturns or even a recession.
- Historically, municipal bonds have offered above-average performance and tend to recover following periods of poor performance.1
- In 2025, current US tax rates are set to expire, which would cause taxes to revert to a higher level if Congress does not intervene. Should this happen, municipal bond holdings could become even more attractive due to their tax-free income streams.
- Where are the opportunities within municipal bonds?
- Munis with A credit ratings are showing wider and more attractive spreads than BBB credits.
- Some sectors have particular appeal, such as airports within the transportation sector or water and sewer within essential services.
- While one panelist mentioned a preference for revenue bonds, general obligation bonds in the US Midwest and Southeast are still considered attractive. Those regions are also considered attractive for investors without state-specific investment goals.
- Given the shape of the yield curve, investors might consider a barbell strategy, focusing on bonds with one-year and 12-year maturities. This gives an investor an average mid-range duration, provides liquidity, captures higher yields over a longer period and would also generate capital appreciation, should interest rates fall.
Municipal bonds may be a good fit for many investors within an overall investment portfolio. Investors can take advantage of potential tax benefits on municipal bonds held in the taxable portion of their portfolios. Munis can diversify existing fixed income holdings or replace fixed income on their own and offer a similar type of risk offset within a portfolio. Within the universe of municipal bonds, there is a wide range of diversity, even with a state-specific constraint. In addition, the credit quality of the municipal universe is higher than corporate fixed income, and defaults tend to be lower. These factors make it an excellent time to consider municipal bond investments, in our view.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.
Active management does not ensure gains or protect against market declines.
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1. Source: Bloomberg, Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. From the period between January 1, 1980, to December 31, 2022. The Bloomberg US Municipal Index covers the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
