As the Federal Reserve raises interest rates, municipal bonds are presenting attractive yields for investors seeking tax-exempt income. With yields on some AAA-rated long-term bonds nearing multi-year highs, experts suggest now is an opportune time to invest, particularly in higher-quality and longer-maturity bonds.
Municipal bonds offer a significant tax advantage, with income exempt from federal taxes and often state and local taxes, leading to higher effective yields compared to traditional Treasury or corporate bonds.
As the Federal Reserve continues its aggressive interest rate hikes, municipal bonds are emerging as a compelling investment avenue for those seeking tax-exempt income. Similar to the Treasury market, muni bond yields remain elevated, presenting an attractive entry point for investors.
The 10-year Treasury yield recently touched the 5% mark, reflecting investor sentiment following the latest Fed announcement and its monetary policy outlook. It's important to remember that bond yields move inversely to prices. The Bloomberg Municipal Bond Index currently offers a yield of approximately 4.3%. However, the significant advantage of municipal bonds lies in their tax-exempt status. Income generated from these bonds is exempt from federal taxes, and for residents of the issuing state, it is also free from state and local taxes.
Chris Gunster, head of fixed income at Fidelis Capital, highlights this benefit, stating, "That translates to a tax-equivalent yield of 7.3% for those in the highest tax bracket. You're not going to find that in the Treasury market. You're not going to find that in the corporate bond market. So we see that as a very attractive place."
The iShares National Muni Bond ETF (MUB), which tracks the investment-grade segment of the muni market, currently boasts a 30-day SEC yield of 3.8% with a low expense ratio of 0.05%.
Market analysts are observing stabilization in the Treasury market, with the yield curve showing signs of flattening. Bank of America strategist Yingchen Li suggests that the Fed's firm stance, coupled with Treasury buybacks of long-term debt, could steady the market and position munis favorably for a potential fall rally.
Barclays, despite acknowledging challenging market technicals, is also increasing its exposure to municipal bonds. Mikhail Foux, head of the firm's municipal research and strategy, notes that widening muni ratios, multi-year high yields, and a more assertive Fed should support longer-term rates, advising investors to gradually increase their holdings, focusing on higher-quality bonds.
Tom Kozlik, head of public policy and municipal strategy at Hilltop Securities, expresses strong conviction in the current muni market, urging investors to "jump in at these levels" rather than just cautiously entering. He points out that AAA-rated municipal bond yields on long-term bonds have rarely approached current levels in the last 26 years, according to Municipal Market Data (MMD).
Finding Opportunities Amidst Volatility
Despite yield fluctuations, the underlying fundamentals of the muni market remain robust. issuers have bolstered reserves and refined their financial management strategies following lessons learned from the Covid-19 pandemic and the 2008 global financial crisis. "They have very strong reserves and have learned how to manage revenues and expenditures, knowing that money from the pandemic has run out and they also have infrastructure needs," noted Nathan Will, head of municipal credit research at Vanguard.
Bank of America favors high-quality, AAA-rated issuers, finding the entire yield curve attractive but highlighting the long end for its potential outperformance. Li anticipates that 10-year AAA spot yields will lead any sustained market reversal, with a flattening of the 2s10s AAA curve expected to begin soon. The issuance of new municipal bonds in September has also increased significantly year-over-year, providing investors with more options.
Kozlik is particularly enthusiastic about longer-maturity bonds, specifically those in the 20 to 30-year range, while cautioning investors about the inherent interest rate risk associated with longer durations. He observes that municipal yields have risen faster than Treasurys, making relative value indicators more attractive, especially for maturities of 20 years and beyond.
For investors with different risk tolerances, Fidelis Capital's Gunster suggests exploring both investment-grade and high-yield muni markets. Within high-yield, he recommends actively managed and broadly diversified funds to mitigate risk. Examples include the iShares High Yield Muni Active ETF (HIMU) with a 5.31% 30-day SEC yield and the Nuveen High Yield Municipal Income ETF (NHYM) with a 4.95% 30-day SEC yield.
In the investment-grade space, Gunster prefers actively managed strategies focusing on A-rated bonds or better, while avoiding sectors like secondary schools and smaller universities. He also emphasizes the opportunity for tax-loss harvesting, a strategy that involves selling assets at a loss to offset capital gains, thereby lowering tax liabilities. "You're simply swapping one 5% bond with another 5% bond, and you carry on," he explained, adding, "If the market gives you this opportunity, you take it."
