Municipal bond investors have taken it on the chin this year: Muni bonds were down 12.13% through Sept. 30, New York Life reports. Taken in stride, though, that seems consistent with investors’ overall experience with the aggregate U.S. bond market, which has plummeted by 14.6% in the same time period, according to Bloomberg.
But for long-term investors in municipals, the drawdown this year has actually been stridently inconsistent with their experience in the last three decades. In fact, since 1994, municipals have experienced a drawdown of 5% or more only seven other times, based on research from New York Life. Most notably, declines of about 11% occurred in both 2020, at the start of the pandemic, and in 2008, during the financial crisis.
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Much of the market volatility investors have experienced this year has been tied to the Federal Reserve’s five interest rate hikes in a span of six months, from essentially zero to a current fed funds range of 3% to 3.25%, which is also the highest level since 2008. For perspective, the Fed’s rate-hike pace in the last six months has been its fastest since the 1988-89 cycle (nearly twice the speed), when rates were lifted in a span of 14 months. To put it mildly, investors simply do not care for aggressive rate hikes.
Perhaps these experiences taken together (the steep drawdowns in tandem with the Fed’s hard-hitting rate hikes) are the backdrop for why investors pulled nearly $12.5 billion from municipal mutual funds and exchange-traded funds, or ETFs, in September, according to data from the Investment Company Institute.
Still, given municipals’ long track record of stability, are there constructive reasons to come back home to these investments? Some experts, like Scott Sprauer, managing director at MacKay Municipal Managers and portfolio manager of the MainStay MacKay municipal bond funds, believe there are a variety of reasons why investors should take a second look at municipal bonds now.
“The current state of the municipal market is very attractive for long-term investors,” says Sprauer, adding that “yields for high-quality credits have increased to levels not seen in at least five years, and underlying fundamentals continue to remain very strong.”
Here are some other factors that suggest it’s time for investors to “come home” to municipal bonds:
— Silver linings for municipal bonds.
— Making lemonade from bond market lemons.
— Muni bonds offer competitive yields.
Silver Linings for Municipal Bonds
The demographics regarding who typically owns municipal bonds and why they are attracted to municipals are relevant here. According to Municipal Bonds for America, 72% of municipal bonds are owned by individuals directly or through mutual funds or ETFs, three-fifths of whom are over age 65. And with a remarkable default rate of only 0.16% (for all rated bonds according to Moody’s) from 1970-2020, stability is the chief reason investors have been attracted to municipal bonds. By comparison, corporate bonds defaulted at a rate of 10.55% in the same time frame.
There are nearly 10,000 individuals who turn 65 each day in the U.S., according to the U.S Census Bureau. Plus, there will be an estimated 73 million baby boomers (individuals born between 1946 and 1964) who are at least age 65 by 2030. These demographic trends are supportive of municipal bond investments.
Another silver lining, but of a different shade, is the manner in which municipal bonds have historically snapped back after periods of drawdowns. New York Life has found that, since 1994, municipals have often experienced double-digit returns in the subsequent 12 months after five of the last seven drawdowns. For example, following the drawdowns of the financial crisis in 2008 and COVID-19 in 2020, municipals bounced back by 19.85% and 13.14%, respectively.
The Tax Cuts and Jobs Act, which reduced personal income tax rates, went into effect in 2018 and will expire in 2025. If marginal tax rates increase in the coming years, then that could serve as a tailwind for municipals as an asset class.
Making Lemonade From Bond Market Lemons
Perhaps it’s a good time to make lemonade from some lemons of this year’s market, with municipal bonds in particular. According to Pimco, there are at least a couple of ways to benefit from the decline in the municipal bond market this year.
As municipal bond prices have declined with each Fed hike, yields have improved dramatically. This scenario has created an excellent entry point for long-term investors who want to take advantage of lower valuations and higher yields among municipals at this time.
Tax-loss harvesting is another strategy suggested by Pimco. This strategy can help investors sell underperforming securities, raise cash for new purchases and potentially reap some tax benefits, such as minimizing capital gains or offsetting ordinary income by up to $3,000 a year (under current law). There are specific “wash-sale rules” for trading securities that investors should consider and perhaps discuss with a qualified tax professional prior to implementing a tax-loss harvesting strategy.
Muni Bonds Offer Competitive Yields
One key decision point for municipal investors is whether the tax-equivalent yield from municipal bonds is attractive relative to taxable alternatives, such as corporate bonds. As of July 31, according to Bloomberg, the tax-equivalent yield for AA- municipal bonds was 4.71%, which was higher than the 4.33% yield from BBB+ U.S. corporate bonds. (This calculation includes the 37% top federal marginal income tax rate, plus a 3.8% net investment income tax to fund Medicare.) For investors who live in high-tax states, such as New York and California, the tax-equivalent yields from municipals were above 5% as of the end of July.
Because yields have improved among municipal bonds this year, it means that investors no longer have to stretch for competitive income from lower-quality investments. And if valuations among municipals snap back as they have in the previous three decades, then investors’ source for competitive returns will also be closer to home.
“With respect to municipals, we feel confident that investors will look back at the current market and realize this was a once-in-a-decade opportunity,” says Sprauer.
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Is It Time to Invest in Municipal Bonds? originally appeared on usnews.com
