Interest rates are low. The yields aren’t exactly jaw-dropping. Legislative and regulatory back-and-forths in Washington have injected increased volatility into what is traditionally considered a safe, stable asset class — municipal bonds.
But still,
“At some level, if you're making a lot of money and taking RMDs out of a traditional IRA, and you're getting Social Security, and you're getting a pension, those taxes can really add up. So to have municipal bond interest that is tax-free, you're not adding to your tax load,” Benold said. “Do I need to put it into the portfolio of someone who is 30 years old? No. But definitely for retirees, this is not going away.
“Interest rates are going to go up, which means the prices of the munis are going to go down, so you're going to see a little trickle out of it. But at the end of the day, these are very stable assets that should be in your account just to give you tax-free interest to reduce your tax bill.”
Munis hold steady in a wild year
The compressed spreads and low yields of the current municipal bond market made finding worthy returns difficult for investors in 2021.
Any potential hike in tax rates in 2022 should change the landscape and bolster investor demand, but a host of factors have led to the past 12 months being an interesting year for munis.
Fears early in the year that COVID would be a burden too heavy for many municipalities to bear and lead to significant downgrades were largely unfounded. Local economies recovered, and federal support packages helped state and local governments address revenue loss related to the ongoing pandemic. Munis held their value.
November also proved to be another month of headlines in the fixed income market with the Federal Reserve announcing that it will taper bond purchases in December, and President Joe Biden’s infrastructure package leaving munis untouched.
As Washington weighed in, so did investors. November saw cash flow back into tax-exempt debt, breaking three months of losses as muni yields stabilized after reaching their highest levels of the year.
But Benold says the longstanding attractive qualities of munis have endured despite all of the ebbs and flows. He credits investors in high tax brackets dumping money into the asset class for tax-free interest in return as one of the biggest driving factors. But the rush to safety should not be overlooked.
“No one knew with coronavirus what was going to happen with markets, and muni bonds historically are ultra safe assets. Especially when you get into a muni bond fund where there's a lot of different diversity,” Benold said. “You get really good diversity and the default rate would be minuscule. So the guarantee of getting paid your interest is almost 100%.”
He adds that muni bonds are a great option for investors who are simply no longer interested in the big risk, big return play. For these clients, slow and steady is more appealing.
“If you've earned this high dollar amount in your nest egg and you’re retired, do you even need to take the risk? Do you need to have all those stocks? Or are you in a position where you can just be in muni bonds, sail into the sunset and be OK? You’ll sleep well at night and not have to worry about your Investments,” he said.
Where’s the competition?
Bill Merz, senior vice president and head of fixed income research at U.S. Bank Wealth Management, said part of what’s driving munis in this low-rate environment is a lack of better alternatives.
Even with very low absolute yields in the municipal space, highly taxed investors can generate as much or more yield in municipals as they can in corporate bonds.
“For an investor who has used municipals for years, the yield incentive to change their investment approach and shift to buying corporate bonds isn’t there,” he said. “While corporates represent a larger and more liquid market, with easier credit monitoring, most investors would want a meaningful yield incentive to switch.”.
Additionally, municipal credit quality improved considerably over the last 18 months, with state and local tax revenues near all-time highs, which lends support to higher-than-normal valuations, Merz said.
And while the municipal market has evolved considerably over the years, low historical default rates mask some risks in parts of the muni market. Bonds backed by single projects and for-profit issuers have grown, making corners of today’s municipal market more complex than what it used to be.
“Due to the sheer number of municipal bonds that exist, riskier or more complex bonds can trade comparably to more plain-vanilla bonds. Investors increasingly understand they need active credit oversight to screen out bonds that would introduce unnecessary risks without commensurate compensation,” he said.
Increased taxable issuance, reasonable yields compared to corporate bonds and portfolio diversification characteristics have certainly boosted the utilization of taxable munis, Merz said. However, it remains a relatively small market, and individual municipal investors still prioritize stable non-taxable income.
Because of that, Merz said there hasn’t yet been a significant shift.
“We expect taxable issuance to dip somewhat next year barring any significant legislative changes, which will slow the recent trend of taxable issuance crowding out non-taxables,” he said.
New points of entry
A large number of individuals are getting their exposure through some professionally managed accounts, whether exchange-traded funds, mutual funds or separately managed accounts, and the concentration of demand has moved into a much smaller number of strategies.
CreditSights Senior Municipal Strategist Patrick Luby said that a generation ago, when the bond market was in a multi-decade rally as yields came down, there was a general perception that investing in munis was not that difficult.
“The economy was growing, interest rates were coming down. If you bought bonds, they generally improved in value overall. So there was a higher comfort level of self-directing a portfolio,” he said.
But after the financial crisis of 2008, investors were more scared to handle their own bond investing.
“Having professionally-managed, full-time supervision over a muni portfolio is way more appropriate now than maybe it was 10 or 15 years ago because of the lower interest rate environment and the risk of volatility,” Luby said.
Spread compression has made it more difficult for individual advisors to justify spending the time necessary to talk about individual bonds to their clients. While the decreased spreads suggests smaller upside for investing in bonds, Luby said it doesn’t necessarily mean the downside has been reduced, as tighter spreads also mean there’s less margin for error.
According to Merz, the municipal market has consolidated over time, making it more difficult to trade in smaller increments.
A small investor buying one or two bonds at a time through their broker isn’t efficient from the perspective of wide bid/ask spreads, which reduces yield and return. He said smaller investors are usually better off investing in strategies where they receive active credit monitoring, diversification and highly efficient execution because the manager is trading in size.
The appeal of taxable munis
Retail investors have anecdotally pivoted to taxable munis, something Luby said makes sense as muni yields aren’t attractive right now if an investor is near the maximum federal income tax bracket.
But for a retiree no longer in a 37% tax bracket, he or she might see better tax-adjusted income off a taxable muni and have a similar credit risk.
“There's a lot of longtime muni investors who, if you show them a corporate bond, they may be less comfortable with the credit risk of a corporate than with a muni,” Luby said. “So if you show them a taxable muni, they're familiar with state [general obligation bonds] or Stanford University or a big hospital that they know. They may be more comfortable with that credit risk, and because it could, depending upon their tax rate, provide higher tax-adjusted income that can make it easier to trade.”
But Steve Skancke, Chief Economic Adviser at Keel Point, said while he has seen some value in taxable munis for investors who don't have a significant tax consideration, they’re far from a “go-to.”
“It can be an opportunity to pick up some extra yield. With the fact that the market is less robust and more thinly traded, you have to be careful about liquidity because some of those are thinly traded enough that if you need to come out of a big decision quickly it can affect the price that you get,” he said. “But we don't use them much. We have a couple of times for some clients and it has been effective in certain situations, but there are other investment-grade corporate (bonds) or even just below investment-grade that can provide a comparable or slightly better risk-adjusted return.”
Luby said for most market participants, current tax yields don't appear to be compelling. While munis are priced right now attractively for individual investors, tax-exempt munis aren’t as attractive for banks, insurance companies and corporations because they pay a lower rate.
If the market gets weak or enters a “short down move” without having those additional buyers in the market, liquidity will be greatly reduced.
“So in down market conditions, I think the downside risk and the downside volatility will be much more exaggerated than investors saw in the past,” Luby said.
He added that investors are rebalancing asset allocations to reduce equity market exposure. Consequently, significant sums of new money have been flowing into fixed-income funds, but not all of it appears to be invested in.
Making munis work for your clients
Skancke said advisors looking to more efficiently employ munis in client portfolios should pay close attention to tax equivalent yields in the comparable maturities.
He said over the last year, there were situations where muni bond yields were higher than their equivalent majority Treasury, even for AA issuers. Likewise, advisors could also see munis below what would be a tax equivalent yield to a comparable Treasury or solid corporate bond.
“Try to get an understanding of what drives the differences, and then find a manager that can be feeding you information as to where there are particularly good opportunities to allocate to munis versus taxable,” Skancke said. “It is going to be more difficult over the next few years just because of these headwinds and tailwinds in the marketplace. But we still believe that they offer a good opportunity.”
For a mutual fund portfolio manager, if they're taking in money, they have to balance different priorities and make sure they have cash on hand to fund redemptions should investors want their money back. If there's a lack of supply, fund managers may think that it's prudent to be patient and wait to invest inflows that have come into the portfolio, Luby said
“Professional portfolio managers, as a rule, don't try to time the market. But they also don't like to be rushed,” Luby said. “And just because somebody wants to put money to work doesn't necessarily mean that the right bonds are always available. So it can take a lot to put money to work.”
