Will Muni Bonds Recover from Market Volatility

Muni bonds have been taking a hit in the market, but the good news is that they've historically been resilient in times of turmoil. In fact, 75% of municipal bond defaults occur during economic downturns, but the overall default rate is still relatively low at around 0.5%.

The municipal bond market has a long history of stability, with some bonds still paying interest rates of 4-6% or more. This is because muni bonds are backed by the credit of local governments, which have a strong track record of paying their debts.

Investors who have held onto their muni bonds during market volatility have been rewarded with steady returns. For example, the iShares National Muni Bond ETF (MUB) has a 10-year annualized return of around 4.5%.

The municipal bond market is well positioned to begin the fourth quarter, with supply expected to ease and demand to strengthen. Issuers brought deals that had been long delayed due to execution uncertainty, and these deals have been routinely oversubscribed.

Yields remain historically elevated, at nearly 100 basis points above the trailing 10-year average. This means investors may enjoy attractive total returns from income alone, a dynamic that has been absent for nearly a decade.

Favorable technical conditions for municipals should begin in November, as continued reinvestment demand from another Fed rate cut combines with slower issuance. Investor fund flows stemming from cash on the sidelines may see continued strength.

The yield curve should steepen more meaningfully as the Fed continues to cut rates. This environment should be positive for longer-duration bonds, which offer higher income and additional total return through declining rates and rolling down the yield curve.

Municipal credit is in a strong position to weather potential economic uncertainty, with statutory reserves remaining high despite excess reserves being drawn down.

If the Fed starts to cut rates, cash and cash-like instruments will likely underperform fixed income. This is because fixed income investments like municipal bonds tend to perform better in a lower interest rate environment.

To take advantage of higher yields in municipal bonds, consider investing in a diversified portfolio of municipal bonds through a mutual fund. This can offer one-decision access to this asset class.

As the market normalizes and longer maturity bonds start to yield more than shorter maturity bonds, we believe this presents investment opportunities. It's the ideal time to move further out on the yield curve.

Municipal bonds are currently offering higher tax-equivalent yields than investment grade corporate bonds. This is because the municipal bond interest is generally exempt from federal taxes and, in some cases, state and local income taxes.

Here are some key benefits of municipal bonds:

Many state and local governments have built up "rainy-day" funds from pandemic-era stimulus money and better-than-expected tax collections. These reserves could create opportunities for certain issues and issuers.

Municipal bonds are not immune to risks, but there are some encouraging signs for recovery.

Interest rates were on the rise, and cash outperformed most fixed income, but now that rates have likely stabilized, investors may be able to unlock the total return potential from longer-dated bonds.

State and local governments have built up "rainy-day" funds from pandemic-era stimulus money and better-than-expected tax collections.

These reserves could create opportunities for certain issues and issuers, where skilled money managers can be beneficial.

The municipal tax-equivalent yield is calculated using a 40.8% tax bracket, which includes a 37.0% top federal marginal income tax rate and a 3.8% Net Investment Income Tax to fund Medicare.

Different tax brackets will have different results.

States have significantly increased their rainy day reserves, with the National Association of State Budget Officers (NASBO) Fiscal Survey of States reporting this in January 2024.