Reasons for Optimism with Municipal Bonds

Continuing with the theme of this being a trying time for clients that need or dare desire fixed income exposure, municipal bonds are slumping owing to rising interest rates.

The widely followed ICE AMT-Free US National Municipal Index is lower 5.52% year-to-date. Believe it or not, that’s worse than the loss notched by the S&P 500. Of course, the devil is in the details. While many clients are programmed to believe to nearly all bond categories will be plagued by rising interest, history indicates the opposite is actually true with munis.

Over the past 26 years -- a period that’s included a variety of credit and interest rate climates – municipal bonds traded lower an annual basis less than 20% of the time. That’s encouraging, particularly for older clients that need low-risk income.

That could also be a sign that while munis are off to a rough start this year, a rebound could materialize as 2022 moves forward. After all, the lower a bond’s starting price is when a client gets involved, the great upside potential there is.

“Bank of America Corp. says the worst of this year’s selloff in the municipal bond market might already be over, though there may be some additional pain in March after the Federal Reserve’s rate decision,” reports Skylar Woodhouse for Bloomberg.

Muni Points to Ponder

Clients – and this is why they have advisors – likely don’t know about the muni-treasury ratio, which can be instructive when evaluating municipal bond funds.

“While the municipal bond market generally follows rate changes in the U.S. Treasury market, it does not move in lock step, which is why sometimes we see muni-treasury ratios upwards of 80% to low 90%,” says Jim Colby, VanEck portfolio manager. This is because the typically low volatility of munis is directly related to the fact that only approximately 2% of all outstanding bonds trade in a given day, making it challenging to reprice all of the bonds that do not trade.

As Colby notes, munis offer more immunity to rising rates than meets eye. That could signal that this year’s weakness belies historical trends and could reverse course.

“Over a long history of Fed rate policy changes across a variety of market cycles, municipal bonds have consistently delivered positive returns. A contributing factor is that the tax exemption is valuable in all rate and tax environments to many types of investors,” adds VanEck’s Colby.

Talking Total Returns

Another point many clients probably aren’t aware of is that a bond’s total returns are a combination of price action and income – always an important concept and certainly so today.

“The prevailing coupon of most municipal issues is 5%, and since total return includes both price movements as well as income, greater price declines than we have seen recently would need to continue through the balance of the year, which we feel is unlikely,” concludes Colby. “We believe it is likely that 2022 will also deliver modestly positive performance by year-end.”

To that end, most clients are likely to be well served by defensive, higher quality munis.

“We prefer an up in quality bias overall while adding select high yield credits amid more attractive prices. We continue to focus on defensive sectors and pay particular attention to bond structures, favoring those with higher coupons and shorter calls,” according to BlackRock.

Related: Surge In Bond Yields Says It’s Time To Buy Bonds