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Future Yields: Navigating the Municipal Bond Market

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The prospect of a tax hike has fueled interest in municipal bonds since state elections in Georgia secured Democrats a slim majority in Congress earlier this year.

This is because municipal bonds allow investors to earn tax-free income. But the benefits of owning the highest quality of these tax-free securities over treasury bills or higher-grade corporate bonds have diminished as the munis rush pushed prices up and yields down. decrease.

The worst-case return (the lowest potential return for a security) of the S&P Municipal Bond Index was just 1.03% on Monday, slightly above the low of 0.92% reached on July 27 this year. year. For comparison, the 10-year US Treasury closed on Monday at a yield of 1.36%

But high prices and low yields have not dampened investor interest in munis. Estimated net cash flow in municipal bond mutual funds and exchange-traded funds reached US $ 79.25 billion at the end of August this year, compared to US $ 15.73 billion at the end of August this year. over the same period a year ago, according to data from Refinitiv Lipper. These are the biggest inflows of municipal bonds on record, according to the company, a unit of the London Stock Exchange Group.

It’s only been a week or two in the past 60 years that we haven’t had positive cash flow in municipal bond funds, says John Flahive, head of fixed income investments at BNY Mellon Wealth Management.

Penta recently spoke with Flahive about how high net worth investors should approach the municipal bond market amid low interest rates in the fixed income world.

A rapidly declining ratio

Before the pandemic, the yield on 10-year triple-A rated municipal bonds was about 85% to 90% of the 10-year Treasury yield. For investors in a 40% tax bracket, the taxable equivalent return on these municipal securities would be 0.30 to 0.50 percentage points higher (depending on the security’s yield at the time), Flahive says.

But municipal bond prices fell and yields rose in the first months of 2020, with investors worried that lockdowns linked to the pandemic could cause financial hardship for state and local governments. This would mean that they might find it difficult to make bond payments to investors.

As a result, municipal bond yields reached nearly four times comparable T-bills at the end of March 2020, according to a Brookings study.

But the Federal Reserve’s interventions at the height of the crisis quickly allayed fears. By the time the municipal securities pandemic eligibility for the Fed’s commercial paper financing facility and the money market mutual fund liquidity facility expired on March 31, municipal rates had fallen to about 50% of comparable T-bills, Brookings researchers wrote in a 31 post.

As Flahive noted in a mid-year bond market report, the yield on 30-year AAA-rated municipal bonds rose only 0.07 percentage points in the first half of this year, compared to a gain. 0.47 percentage point for the 30-year Treasury. yields.

Munis’ relative after-tax advantage is thus historically low on all maturities in the first half of the year. Today, the tax equivalent yield differential between munis and treasury bills is so small that in some cases it doesn’t exist at all, says Flahive.

Total returns for munis have also been modest. The Vanguard Tax-Exempt Bond fund, a national intermediate municipal bond fund worth $ 14 billion, returned 1.32% through Monday, September 13, up from 4.98% in 2020 and 7.45% in 2019, according to Morningstar.

The credit outlook for municipal titles, meanwhile, is as favorable as one can remember given federal fiscal stimulus during the pandemic, Flahive said in the mid-year report. Although this stimulus inflated general fund balances, he warned that the expenditure budgets of these municipalities would increase, which could make it more difficult to manage in the event of an economic downturn.

It’s always worth owning

For high net worth investors, the tax advantages of municipal bonds mean that the securities are worth buying versus taxable securities of similar credit quality and with a term of more than five years.

However, it is more important for investors to have a diversified portfolio of fixed income securities. According to Flahive, investors should even consider forgoing some after-tax return to include taxable bonds among their holdings.

There is nothing wrong with going up against certain companies, and for those who can take risks, there is nothing wrong. [with having] exposure to high yield bonds, floating rates and maybe even emerging markets, he says.

Stick to obligations

Even with rates low overall, BNY Mellon says investors, in general, should hold bonds, even if it is a wise amount. While a generic moderate-risk portfolio may typically require 60% stocks and 40% bonds (taxable and non-taxable), for example, the high-level recommendation of wealth managers is now for something less than 30% in fixed income securities. , says Flahive.

Of this roughly 30% allocation, most should be core securities, such as intermediate municipal bonds. Typically, this allocation should include about 80% municipal securities issued by the state (for those who live in states with good bond ratings, such as New York or California), and about 20% national bonds. The portfolio should be diversified between income bonds (used to fund specific projects) and general bonds.

Another about 6% of the total fixed income allocation could then be invested in riskier, higher yielding securities, including opportunistic municipal bond strategies, he says.

You are probably better off taking a diversified fixed income approach even though you may be taking more volatility asset class by asset class, [because] at least it’s not a single asset class, says Flahive.

Sources

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2/ https://www.barrons.com/articles/future-returns-navigating-the-municipal-bond-market-01631649483

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