With the Federal Reserve continuing its rate hike cycle, municipal bonds are emerging as a compelling investment opportunity for individuals seeking tax-exempt income. Despite elevated Treasury yields, munis offer competitive after-tax returns, with a 10-year Treasury hitting 5% and the Bloomberg Municipal Bond Index yielding around 4.3%. However, due to tax exemptions, the effective yield on munis can reach up to 7.3% for those in the highest tax brackets, a level unmatched in other bond markets.
Strategists suggest that recent Treasury buybacks and the Fed’s firm monetary policy may stabilize the market, paving the way for a municipal bond rally. With yields nearing multi-year highs and strong underlying fundamentals among issuers, experts recommend actively investing rather than cautiously entering the market, with a particular focus on higher-quality and longer-maturity bonds.
The Federal Reserve's aggressive interest rate hikes are creating a fertile ground for municipal bond investors, presenting attractive entry points for those seeking tax-exempt income. As yields in the Treasury market climb, municipal bonds are following suit, offering competitive returns that are further enhanced by their tax advantages.
On Friday, the 10-year Treasury yield reached the 5% mark, reflecting investor reactions to the Fed's latest monetary policy decisions. While bond prices and yields move inversely, the current elevated yield environment in Treasurys is mirrored in the municipal market. The Bloomberg Municipal Bond Index is currently yielding approximately 4.3%.
However, the true allure of municipal bonds lies in their tax benefits. Income generated from munis is exempt from federal taxes and, for residents of the issuing state, also from local taxes. Chris Gunster, head of fixed income at Fidelis Capital, highlights this advantage, stating that for individuals in the highest tax brackets, this translates to a tax-equivalent yield of 7.3%. "You're not going to find that in the Treasury market. You're not going to find that in the corporate bond market," Gunster remarked, emphasizing the unique appeal of munis. "So we see that as a very attractive place."
The iShares National Muni Bond ETF (MUB), a tracker of the investment-grade municipal bond market, currently offers a 30-day SEC yield of 3.8% with a low expense ratio of 0.05%. Data for MUB year-to-date indicates its performance.
Market strategists are observing a stabilization trend in the Treasury market, with a notable flattening of the yield curve this week, according to Yingchen Li, a strategist at Bank of America. Li anticipates that the Fed's firm stance and the Treasury Department's buyback of long-term debt could stabilize the market, positioning municipal bonds favorably for a potential fall rally.
The Treasury Department's announcement last week to buy back up to $6 billion in longer-term debt is seen as a move to manage Treasury yields. Barclays, despite acknowledging challenging market technicals, is also increasing its exposure to the municipal market. Mikhail Foux, head of municipal research and strategy at Barclays, noted in a recent memo that widening muni ratios, multi-year high index yields, and a more assertive Fed are creating a favorable environment. He advises investors to gradually increase their exposure, focusing on higher-quality bonds.
Muni ratios are a key indicator, reflecting the yield difference between municipal and Treasury bonds of similar maturities. Tom Kozlik, head of public policy and municipal strategy at Hilltop Securities, believes the current yield levels present a compelling buying opportunity. "I wouldn't just be dipping my toe into the municipal market right now. I'd be jumping in at these levels," he urged. Historical data from Municipal Market Data (MMD) shows that AAA-rated long-term municipal bond yields have rarely approached current levels over the past 26 years.
Despite yield volatility, the underlying fundamentals of the municipal market remain robust. Issuers have learned valuable lessons from past financial crises, including the Global Financial Crisis (GFC) and the Covid-19 pandemic. Nathan Will, head of municipal credit research at Vanguard, points out that many issuers now maintain strong reserves and have refined their revenue and expenditure management strategies, especially as pandemic-related funds diminish and infrastructure needs persist.
Bank of America favors high-quality issuers, particularly those with AAA ratings. While the entire municipal curve is considered attractive, the long end is identified as having the greatest potential for outperformance. Li predicts that the 10-year AAA spot yield will lead any sustainable market reversal, with a 2s10s AAA flattening trend beginning shortly.
The timing for investment is also opportune, with September issuance of municipal bonds approximately 50% higher year-over-year, and new money issuance up by 74%. This increased supply provides investors with a broader selection of bonds. Kozlik specifically recommends longer-maturity bonds, ranging from 20 to 30 years, while cautioning about the inherent interest rate risk associated with longer durations.
Fidelis Capital's Gunster suggests that investors can explore both investment-grade and high-yield municipal markets, depending on their risk appetite. For high-yield options, 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 a 0.4% expense ratio, and the Nuveen High Yield Municipal Income ETF (NHYM), offering a 4.39% 30-day SEC yield and a 0.35% expense ratio. Data for HIMU year-to-date shows its performance.
Within the investment-grade space, Gunster prefers actively managed strategies focusing on high-quality A-rated bonds or better. He advises avoiding specific sectors like secondary schools and smaller educational institutions. Gunster also utilizes tax-loss harvesting strategies, where assets sold at a loss are used to offset capital gains, thereby reducing tax liabilities. "We can sell one bond at a loss and purchase another bond, and thereby handing the client a tax benefit, a loss that can be applied to other portions of the portfolio," he explained. "You're simply swapping one 5% bond with another 5% bond, and you carry on." Gunster concludes, "If the market gives you this opportunity, you take it."
