Without getting to the sudden and arguably unnecessary debate regarding the definition of a recession, it’s safe to say most advisors are accustomed to two consecutive quarters of declining GDP growth being cause for concern.
That’s the scenario the U.S. economy is dealing with today. So whether the economy is fitting the technical or literal definition of recession, now could be an opportune time for advisors to discuss with clients assets with recession protection reputations.
As advisors well know, bonds are usually a primary destination for client portfolios when the economy contracts, but that thesis is certainly being tested with the Bloomberg US Aggregate Bond Index down 10% year-to-date. Compounding the problem are recent comments from Federal Reserve Chairman Jerome Powell indicating the central bank will remain vigilant in the fight against inflation. Translation: Don’t be shocked if there’s a rate hike of 75 basis points in September.
Still, hope is not lost across the entire fixed income spectrum. In fact, some experts argue municipal bonds are positioned to offer clients needed protection if a traditional recession sets in and stays longer than market participants expect.
Muni Proof in the Pudding
To be sure, municipal bonds aren’t setting the bond market ablaze this year, but they are outperforming broader fixed income benchmarks.
As of Friday, Aug. 26, the ICE AMT-Free US National Municipal Index is outpacing the aforementioned Bloomberg US Aggregate Bond Index by 230 basis points year-to-date. That’s a wide enough gap that advisors should take note. Other points indicate munis are positioned favorably for trying economic times.
“Nearly 70% of the broad municipal bond index is rated in the top two ratings categories—AAA or AA,” notes Cooper Howard of Charles Schwab. “This compares to the corporate market where a little over 8% is rated either AAA or AA. Higher-rated issuers, on average, have more stable revenue sources and greater financial flexibility than lower-rated issuers. This can help buffer the negative financial impact of a recession.”
Then there’s tax collections. Plenty of clients aren’t well-versed in the “plumbing” of municipal bonds – it’s not their job to be – making the issue of tax revenue an interesting conversation point for advisors. Good news: Tax collections are currently sturdy, lending credibility to the munis-in-a-recession thesis.
“Historically, tax revenues have declined following a recession, but the negative impact is usually long after the recession has already started. For example, tax revenues held up during the first few years of the 2007-2008 recession,” adds Howard. “Revenues didn't start substantially declining until 2010. This long lead time gives state and local governments ample planning time to adjust expenses.”
Why Munis Could Be Marvelous
Obviously, credit quality is a major consideration for clients in any corner of the bond market and there are encouraging signs in that regard when it comes to municipal debt.
Historically, muni ratings held up well in recessions. In today’s environment, credit quality across the municipal bond landscape is impressive, indicating the asset class is displaying little vulnerability to a recession – even a lengthy one.
“In addition to an already strong starting point, credit conditions in the municipal bond market have been improving. Conditions for most state and local governments are strong, in our view, due to the substantial fiscal support after the start of the COVID-19 crisis,” concludes Howard.
Consider this: Even Illinois, which is the state with the worst municipal bond ratings, has $1 billion in its rainy day coffers. That’s notable and speaks to recession protection across the broader muni bond arena.