In sailing, a good captain understands how to effectively position their boat to take advantage of changing tides and currents. This is an apt analogy, in our view, for municipal bond investors, because although the surface of the water may not look that much different, the environment below the surface has shifted quite a bit recently.
Over the past few months, there have been three major themes that have emerged in the municipal bond market:
- Attractive absolute yields;
- Low relative yields that are likely here to stay for the near future;
- Credit quality that has peaked but should remain resilient.
Municipal bonds, or munis, are issued by cities, states, and local governments and often pay interest income that is exempt from federal income taxes and potentially state income taxes if purchased from an issuer in your home state. As a result of their tax benefits, they tend to be an attractive option for high-income earners looking for more conservative investment choices.
Recent market update
It has been a difficult start to the year for most fixed income investments, and munis largely haven't been immune to it. The broad muni index is almost flat for the year, but it's outperforming the Bloomberg US Aggregate Bond Index, Treasuries, and investment-grade corporate bonds. In recent years when the broad index was down, it was mostly attributable to rising rates dragging down the prices of the longer-term bonds in the index, but that's not the case so far this year. This year's performance is largely due to higher-rated issuers underperforming lower-rated issuers. Bond prices and yields move opposite one another, and generally speaking prices for longer-term bonds are more sensitive to changes in interest rates compared to shorter-term bonds.
Going forward, we continue to expect lower-rated issuers to perform relatively well compared to higher-rated issuers. Credit quality has remained a bright spot for most issuers and we don't expect that to change soon. Additionally, the higher yields that lower-rated issuers generally offer should help offset further price declines if rates continue to move higher.
Although down for the year, munis are outperforming Treasuries, corporates, and the Agg
Source: Bloomberg Indices, as of 3/15/2024.
Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Total returns from 12/31/2023 through 03/15/2024. Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Indexes representing the investment types are: Preferreds = ICE BofA Fixed Rate Preferred Securities Index; HY Corporates = Bloomberg US High Yield Very Liquid (VLI) Index; IG Corporates = Bloomberg U.S. Corporate Bond Index; US Aggregate = Bloomberg U.S. Aggregate Index; Municipals = Bloomberg US Municipal Bond Index; Treasuries = Bloomberg U.S. Treasury Index; EM (USD) = Bloomberg Emerging Markets USD Aggregate Bond Index; Securitized = Bloomberg US Securitized Index; Agencies = Bloomberg U.S. Agency Bond Total Return Index; TIPS = Bloomberg US Treasury Inflation-Protected Securities (TIPS) Index; Int. developed (x-USD) = Bloomberg Global Aggregate ex-USD Bond Index. Past performance is no guarantee of future results.
Attractive absolute yields
Like most other fixed income investments, municipal bond yields have risen significantly since late 2021 and are now at levels that largely haven't been reached during the past decade. Although yields are down from their recent highs, we still think they're an attractive option for investors in higher tax brackets looking for more conservative income options. The yield-to-worst on the Bloomberg Municipal Bond Index, a broad index of munis, is roughly 3.4% (yield-to-worst is the lowest possible yield that can be received on a bond, barring default, with an early maturity provision like a call feature which allows the issuer to redeem the bond prior to maturity at a stated price). For an investor in the top tax bracket who's in a high-tax state like New York or California, to achieve that same 3.4%, they would need a yield of close to 7% with a fully taxable bond.
The tax-equivalent yield for a broad index of munis is near 7% for investors in the top tax bracket
Source: Bloomberg Municipal Bond Index, as of 3/13/2024.
Assumes a federal tax rate of 39.6% in 2000, 39.1% in 2001, 38.6% in 2002, 35.0% from 2003 – 2012, 39.6% from 2013 – 2017, and 37.0% from 2018 - 2024, a Net Investment Income Tax (NIIT) tax rate of 3.8%, and a state tax rate of 10.0%. For illustrative purposes only. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly.
Low relative yields that are likely here to stay
A common metric to compare the attractiveness of highly rated munis is the muni-to-Treasury ratio, which is also known as the MOB spread. It compares the yield on a AAA rated muni to that of a Treasury before factoring in the effect of taxes.1 Over the past decade, the average 10-year muni-to-Treasury ratio has steadily declined from above 100% to 60% in 2024 which has implications for investors.
The average 10-year muni-to-Treasury ratio has fallen over the past decade
Source: Bloomberg, as of 3/15/2024.
Past performance is no guarantee of future results.
There are a couple of possible explanations why ratios have declined over time, but we believe the most likely is due to supply-and-demand factors. Since 2015, when the 10-year ratio averaged over 100%, the market value of munis outstanding has only increased 4% before considering the impact of inflation. After considering the impact of inflation, the muni market has shrunk in size over the past decade, which is unlike most other major fixed income markets. Additionally, demand for tax-exempt income has increased over the past decade. This is due to a confluence of factors such as an aging and wealthier population and the 2017 Tax Cuts and Jobs Acts eliminating some popular tax deductions for investors in high-tax states like California and New York, which are major issuers of munis.
The market value of munis outstanding has only increased by about 4% since 2015
Source: Securities Industry and Financial Markets Association (SIFMA), as of Q3 2023, which is the most recent data available.
For illustrative purposes only.
Going forward, these are broader trends that we don't expect to reverse anytime soon, which means that low relative yields are likely here to stay.
This all has important implications for investors. First, low relative yields mean investors who are not in the top federal tax brackets should consider Treasuries or certificates of deposit (CDs) instead of AAA rated munis if looking for highly rated investment options. For example, a 10-year Treasury currently yields about 4.3%, compared with about 2.5% for a generic 10-year AAA rated muni. After considering the effect of taxes, the muni index yields about the same as the Treasury for an investor who is subject to the top tax rates.
AAA-rated muni yields relative to Treasuries at different tax rates
Source: Bloomberg, as of 3/15/2024.
AAA munis are represented by the 10-year portion of the Bloomberg AAA BVAL Curve (Bloomberg Valuation Service). Treasuries are represented by the Generic United States 10-year Government Note.
AAA rated munis are represented by the Bloomberg BVAL curve. Assumes an additional 3.8% NIIT tax for the 32%-and-above brackets. Past performance is no guarantee of future results.
The story doesn't change dramatically for most parts of the yield curve. As illustrated in the chart below, an index of generic AAA-rated munis yields almost the same as Treasuries after-taxes inside of 10-years.
AAA rated munis currently yield roughly the same as Treasuries after taxes for investors in the top tax bracket inside of 10 years
Source: Bloomberg, as of 3/15/2024.
AAA-rated munis are represented by the Bloomberg BVAL curve. Treasuries after tax assumes a 37% federal and an additional 3.8% NIIT tax. Treasuries are represented by the US Treasury Actives Curve.
Another implication of low relative yields is that we believe more attractive investor opportunities can be found by focusing on lower rated investment grade munis. Credit spreads, the additional yield for investing in issuers that aren't AAA-rated, are off their lows from about a year ago and are near the average since the start of 2009. Right now, the sweet spot appears to be A-rated issuers in our view. We believe they provide an attractive balance of some additional yield without taking on too much credit risk.
Taking on some credit risk looks attractive because credit spreads are near their longer-term averages
Source: Components of the Bloomberg Municipal Bond Index, as of 3/1/2024.
The spread is the difference in yield between the relevant Bloomberg index and the duration matched Bloomberg BVAL AAA Index. BPS refers to basis points, a term primarily used to denote changes in interest rates. One basis point is equivalent to one one-hundredth of one percent, or 0.01%.
The final implication is that if we're wrong that low relative yields are here to stay, it would mean munis underperform Treasuries which could have broader asset allocation implications.
Credit quality likely has peaked but should remain resilient
Since 2020, state tax revenues increased rapidly but are now slowing. Historically, following a recession states don't accumulate savings, but the recovery since 2020 has been unique, to put it mildly. Instead of accumulating savings, states have generally had to tap into their savings following the onset of a recession. They do this to supplement social programs, like unemployment or Medicaid, or to offset a decline in tax revenues. Unlike past periods following a recession, after the 2020 recession, many states used the better-than-expected growth in tax revenues, combined with the ample fiscal aid, to build up their reserve levels to record-level highs.
Unlike past recessions, states have accumulated savings following the 2020 recession
Source: Dallas Federal Reserve, as of 12/19/2023.
Data show a percent of annualized state and local government total expenditures, excluding government social benefits payments. Excess savings is the difference between cumulative receipts differences relative to the data implied trend for the 16 quarters prior to and including the business cycle peak as defined by the National Bureau of Economic Research to date and cumulative expenditure differences relative to the data-implied trend for the 16 quarters prior to and including the business cycle peak to date.
It's likely that we're past the peak in credit quality but even if revenues slow further, we believe that most states and local governments are in a good position to manage through the slowdown given the ample reserves they've built up recently. To illustrate, the aggregate state rainy-day fund is nearly 14% of general fund spending, which is the highest level going back to the late 1980s, according to the National Association of State Budget Officers. A rainy-day fund is akin to a savings account that states can tap into, with restrictions, if they need to offset a decline in revenues.
States have built up their rainy-day funds to near record level highs
Source: National Association of State Budget Officers (NASBO), as of 12/19/2023.
What to consider now
Municipal bonds can be an attractive investment option for higher income earners given their tax benefits and generally high credit quality. We suggest extending duration and locking in attractive longer-term yields for investors who have been staying too short. Additionally, the outlook for credit quality has peaked but remains resilient and yields for very highly rated munis are not too attractive relative to alternatives. As a result, we think it makes sense to add some lower-rated investment-grade munis because investors are getting adequately compensated, in our view, for taking on credit risk that is low. For help selecting the right investments, contact your local Schwab representative.
1 The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.
