Muni Bond Outlook: Navigating Market Trends and Credit Risk

As the muni bond market continues to evolve, it's essential to stay informed about the trends and risks that can impact your investments. The market has been growing steadily over the past decade, with total outstanding muni bonds reaching $4.2 trillion in 2020.

Investors are increasingly seeking out tax-exempt bonds as a way to diversify their portfolios and reduce their tax liability. This trend is expected to continue as more states and local governments issue bonds to finance infrastructure projects and other public works.

In recent years, the muni bond market has seen a significant increase in credit risk, with some issuers facing challenges in meeting their debt obligations. This has led to a rise in yields on lower-rated bonds, making them more attractive to investors seeking higher returns.

Municipal bonds are a type of debt obligation issued by nonprofit organizations, private-sector corporations, or public entities for public projects like schools, hospitals, and highways.

They are also known as muni bonds or munis. These bonds can generate tax-free income for qualified residents.

Municipal bonds pay lower coupon (interest) rates compared to taxable bonds, but this comes with the benefit of tax-free income.

Municipal bonds are used for public projects, such as constructing schools, hospitals, and highways.

The demand for municipal bonds is healthy due to their tax-advantages, which has supported their comparative strength in the market.

Municipal bonds shine relative to similar, lower-risk fixed income investments, such as US Treasuries and investment grade bonds.

Currently, tax-free municipal bonds yield 70% as much as US Treasury bonds.

Municipal yields compare favorably with investment grade bonds, offering around 55% of the average investment grade bond's yield.

For certain high-bracket investors, tax-exempt yields for municipal bonds can be more than double those offered by comparable taxable securities.

Municipal bonds offer stability for your capital with low default rates. Interest from munis is also generally exempt from federal taxes, making it an attractive investment.

Munis offer more relative value to bonds with similar risks. They shine relative to similar, lower-risk fixed income investments, such as US Treasuries and investment grade bonds.

Here are some key statistics that illustrate the benefits of munis:

This comparative strength has been supported, in part, by the healthy demand dynamics bolstered by the market’s many tax-advantages.

Municipal bonds offer stability for your capital with low default rates, making them a relatively safe investment option. This is due in part to the low default rates associated with munis.

Interest from municipal bonds is also generally exempt from federal taxes, which can be a significant advantage for investors. This tax-exempt status makes munis an attractive investment choice for those looking to minimize their tax liability.

Securities Industry and Financial Markets Association reports that municipal bonds have a low default rate, which is a key benefit for investors.

Risks of municipal bonds are real, and it's essential to understand them before investing. Default risk is low, but revenue bonds are more vulnerable to economic downturns.

Revenue bonds, like those for a park's shelter area, have uncertain revenue streams compared to GO bonds. For example, a facility delivering water or treating sewage has more dependable revenue.

Market prices of municipal bonds fluctuate with interest rate changes. As interest rates rise, bond prices decline, and when interest rates decline, bond prices rise.

A bond's maturity date affects its susceptibility to interest rate changes. Bonds with longer maturities experience greater changes in value and income.

Many municipal bonds are illiquid, making it difficult to sell them quickly for cash. An investor may need to sell other securities instead.

Some municipal bonds have call provisions, allowing issuers to redeem them before maturity. This can lead to investors losing income from interest payments and facing lower returns on reinvestment.

Tax Efficiency is a key advantage of municipal bonds.

Municipal mutual fund managers can carry over losses to help offset future capital gains. This is particularly beneficial during times of interest rate volatility when interest rates start to come down.

Interest from munis is generally exempt from federal taxes, making it an attractive investment. This tax efficiency can be especially valuable for high-bracket investors who can reap significant benefits from tax-free municipal bond yields.

Here's a breakdown of the relative value of municipal bonds compared to similar, lower-risk fixed income investments:

This comparative strength has been supported by the healthy demand dynamics bolstered by the market's many tax-advantages.

Consider credit risk when investing in municipal bonds. The risk of default is low, but not zero. According to Moody's Investor Services, from 1970 to 2018, only 0.10% of muni bonds defaulted.

The low default rate is due in part to the ability of issuers to raise taxes if necessary. This is especially true after the federal government transferred large amounts of money to municipal governments over the past 3 years, improving the fiscal health of many muni bond issuers.

However, not all muni bonds are created equal. Some areas, such as health care, private higher education, and project finance, may have issuers with less stable financial health. To avoid unnecessarily risky bonds, it's essential to rely on robust fundamental research.

The benefits of municipal bonds, including low default rates and tax-exempt interest, make them an attractive investment option. But it's crucial to consider credit risk and do your research to make informed investment decisions.

A compelling opportunity exists for investors to add exposure to municipal bonds, with attractive yields meeting low default risk. The taxable equivalent yield (TEY) measures what an investor would have to earn on a taxable investment to match the yield of a tax-free municipal bond, and currently, municipal index yields exceed those of cash and rival fixed income investments of higher risk.

Municipal bonds are currently offering higher tax-equivalent yields than investment grade corporate bonds, making them an appealing asset class. They can offer yield without sacrificing credit quality, as the municipal bond interest is generally exempt from federal taxes and, in some cases, state and local income taxes.

The mean ten-year cumulative default rate for all investment grade municipals is only 0.10%, and states have significantly increased their rainy day reserves, creating opportunities for certain issues and issuers. This is supported by data from the National Association of State Budget Officers (NASBO) Fiscal Survey of States, January 2024.

Here are some key statistics that highlight the relative value of municipal bonds:

When investing in municipal bonds, it's essential to understand the different types available. A municipal bond can be categorized based on the source of its interest payments and principal repayments.

A general obligation bond (GO) is a type of municipal bond issued by governmental entities. It's not backed by revenue from a specific project, such as a toll road, and some GO bonds are backed by dedicated property taxes.

A revenue bond secures principal and interest payments through the issuer or via sales, fuel, hotel occupancy, or other taxes. This can provide a more stable source of income for investors.

Some municipal bonds may not be qualified for federal tax exemption, resulting in the generated income being subject to federal taxes. This is something to consider when evaluating the tax implications of a municipal bond investment.

Here are the main types of municipal bonds:

A revenue bond is often used to finance specific projects, such as a toll road or a public transportation system. This type of bond can offer a more targeted investment opportunity for those interested in supporting specific community projects.

Most municipal bonds are issued in $5,000 increments, which can be a significant barrier for some investors.

This means that if you're interested in investing in municipal bonds, you'll typically need to have a substantial amount of money set aside.

Municipal bonds may also be included in exchange-traded funds (ETFs) and mutual funds, making it possible to purchase bond fractions and invest smaller amounts of money.

This can be a more accessible option for those who can't afford the minimum investment amount for a standalone municipal bond.

A compelling opportunity exists for investors to add exposure to municipal bonds, with attractive yields meeting low default risk. This favorable environment may allow investors to achieve their financial goals with less risk.

Taxable equivalent yield (TEY) measures what an investor would have to earn on a taxable investment to match the yield of a tax-free municipal bond. With a federal tax rate of 37% and Medicare surcharge on investment income of 3.8%, TEY assumes a significant difference between taxable and municipal bond yields.

The Bloomberg 10-year Municipal Bond Index and Moody's Investors Service annual municipal bond market snapshot both indicate a low default risk for municipal bonds. In fact, from 1970 to 2022, the mean ten-year cumulative default rate for all investment grade municipals was only 0.10%.

Investors may be able to unlock the total return potential from longer-dated bonds as interest rates have likely stabilized. This presents an investment opportunity, especially for those who believe it's the ideal time to move further out on the yield curve.

Municipal bonds currently offer higher tax-equivalent yields than investment-grade corporate bonds, making them an attractive option for investors. With wide variations in quality among municipal issuers, credit research has always been important in this sector, and today it's even more critical.

Here are some key statistics on municipal bonds:

These statistics highlight the potential benefits of investing in municipal bonds, including their low default risk and attractive yields.

The municipal bond market is poised for a strong fourth quarter, with favorable technical conditions expected to begin in November. Supply has increased meaningfully during the second and third quarters, but deals have been routinely oversubscribed, indicating insatiable demand.

Issuers are bringing deals to market that had been delayed due to execution uncertainty, and investors are eagerly snapping them up. This trend is expected to continue after the election, when supply is likely to taper off.

The yield curve is expected to steepen more meaningfully as the Fed continues to cut rates, making longer-duration bonds an attractive option. Investors can earn higher income and additional total return through a combination of declining rates and rolling down the yield curve.

Here are some key statistics to keep in mind:

Municipal bonds are a popular investment option for those looking for stable returns with relatively low risk.

Municipal bonds are available in a variety of terms ranging from two to 30 years.

Whether you're a seasoned investor or just starting out, it's essential to understand the different term lengths available to make an informed decision.

Municipal bonds can provide a steady stream of income over a fixed period, making them a great option for those seeking predictable returns.

The past year was a challenging one for fixed income investors, with the Federal Reserve raising interest rates to combat inflation. This led to a decline in bond prices, resulting in negative returns for most fixed income asset classes.

In 2023, the Federal Reserve continued its rapid interest rate hikes, seeking to tame inflation. This move put pressure on bond returns, making it a tough year for fixed income investors.

The average 10-year cumulative default rate for US corporate bonds was 2.28%, almost 23 times higher than the default rate for municipal bonds, which stood at 0.10% from 1970 to 2018.

Municipal bonds have historically had one of the lowest default rates of any category of bonds. In fact, from 1970 to 2018, only 0.10% of muni bonds defaulted.

The municipal bond market is well-positioned to begin the fourth quarter, with supply increasing meaningfully during the second and third quarters. Despite heavier issuance, deals have been routinely oversubscribed, indicating strong demand.

Investor fund flows stemming from cash on the sidelines may see continued strength, as T-bills originally purchased in the 5% range are quickly rolling off. Yields remain historically elevated, at nearly 100 basis points (bps) above the trailing 10-year average.

The value of municipal bonds outstanding as of Q4 2023 was $4.1 trillion. This represents a significant market size, offering opportunities for investors to diversify their portfolios.

Municipal bonds are available in a variety of terms ranging from two to 30 years. This allows investors to choose the term length that best suits their investment goals and risk tolerance.

Here are some key statistics on the municipal bond market:

Municipal bonds have traditionally been viewed as a defensive asset class, particularly during times of heightened volatility. This has been the case over the past 50 years, marked by seven recessions, several wars, a global financial crisis, and a global pandemic.

The Bloomberg Municipal Bond Index returned 2.71% in the third quarter, while the Bloomberg U.S. Treasury Bond Index returned 4.74%. This highlights the relative performance of municipal bonds compared to Treasury bonds during the quarter.

High yield municipal credit spreads tightened 1 bps to end the quarter at 198 bps. While broader market tightening was benign, spreads narrowed more meaningfully for hospital bonds and special tax districts.

The increase in long-tenor ratios is driven by increased supply. Deals, while well received, are being priced to sell and preventing the market from keeping pace with the Treasury bond rally. But this supply dynamic is not permanent.

We expect ratios will remain range-bound during October and revert tighter as supply lightens in November, December, and early 2025. This makes the current backdrop attractive for new allocations into municipal bonds.

Diversification is key when it comes to municipal bonds. Owning dozens of municipal bond issues can help spread out an investor's risk, versus concentrating your holdings to only one or two individual bonds.

To get the most out of municipal bonds, consider a tax-efficient mutual fund. These funds may be attractive options, if appropriate.

Professional credit research from a team of analysts can help sift through the large municipal market and identify bonds with attractive risk-reward profiles. This can be a valuable asset in risk management.

Investors have historically looked to municipal bonds for tax-exempt income and relative safety. This makes them a great option for those seeking lower volatility profiles.

Municipal bond mutual funds can be attractive options if you're looking to expand your current position or considering a new tax-efficient investment.

These funds may offer a way to diversify your portfolio and potentially reduce your tax liability.

Whether you're a seasoned investor or just starting out, municipal bond mutual funds can provide a unique opportunity to invest in tax-free or low-tax investments.

Some municipal bond mutual funds may be more attractive than others, depending on your individual financial goals and circumstances.

These funds can be a great option if you're looking to add some stability to your portfolio or generate steady income.

As we look at the muni bond outlook, here are some key statistics and data to consider:

The municipal yield curve steepened during the third quarter, making it an attractive time to invest in municipal bonds.

Currently, there are approximately 200,000 taxpayers subject to the Alternative Minimum Tax (AMT).

If the Tax Cuts and Jobs Act sunsets at the end of 2025, projections suggest that the number of taxpayers subject to the AMT would increase to 7.6 million in 2026.

Here are some key takeaways about the current state of the muni market:

* Investors are seeking high yield municipals due to strong fundamentals and after-tax yields.Investors are looking to extend duration due to the Fed cutting rates and the yield curve steepening.If the Tax Cuts and Jobs Act sunsets, higher tax rates could benefit municipal bonds due to their tax-exempt status.