Five reasons muni bonds offer opportunity in evolving markets

Many investors turn to municipal bonds to add diversification to their portfolio, provide a source of income, and minimize state and federal tax liability. Municipal bonds have also proved resilient in past periods of economic turmoil and should remain a compelling fixed income option for investors.

To combat inflation and slow economic growth, the U.S. Federal Reserve (Fed) began raising the federal funds target rate in 2022, and this continued through July 2023. As a result, rates have increased to pre-global financial crisis¹ levels. With this higher-for-longer narrative, the yield generated by municipal bonds, in our opinion, will remain attractive (Fig. 1).

The credit quality of municipal bonds historically has been strong relative to most other fixed income segments with credit risk, and this appears to hold true for 2024 (Fig. 2). Our team remains confident in the overall enduring credit quality of municipal obligors for two primary reasons:

Better fiscal management post-global financial crisis. Since the global financial crisis, states and local municipalities appear to have implemented more fiscally responsible policies. Many states built their reserves via growth in tax revenues and federal aid. These efforts have helped rebuild the trust of investors in the ability of municipal issuers to remain stable and financially healthy. This trust in credit quality should play an integral role in supporting the long-term performance of municipal bonds.

Coronavirus pandemic funds strengthened many municipal bond issuers. Pandemic‑era funding bolstered states, local municipalities, and many related municipal debt issuers, such as hospitals and airports. Many local governments used the money responsibly to shore up important government‑funded programs like state pensions and school systems. Many other municipal issuers have also seen balance sheet improvements due to pandemic-era funding.

In 2024, governments and other municipal issuers have continued to benefit from the infusion of funding experienced during the onset of the pandemic. This puts a number of muni bond issuers in better fiscal positions than before the pandemic.

In nearly every economic environment, taxes consistently have been a top concern for investors. Due to their preferential tax treatment, municipal bonds have the power to be one of the most impactful tools in building a tax-efficient portfolio.

When moving taxable bond allocations into municipal bonds, investors should consider the tax benefits of munis and how those may result in higher after-tax yield potential (Fig. 3). Taxable bonds, such as corporate bonds, may have a higher pretax yield than a muni bond, but it’s important for investors to consider the tax obligations of that bond. Only after accounting for taxes on the taxable bond can investors accurately compare its yield with that on a tax-exempt bond.

Our current view is that taxes are likely going to stay where they are or possibly increase based on the federal deficit.

While we believe rates will likely stay higher for longer, we do believe we are close to the top of the rate cycle. Going forward, while we are not predicting the timing, it is likely we will see rates come down. Whenever the Fed begins cutting rates, municipal bonds could provide additional price appreciation as rates decline (bond yields and prices move in opposite directions). We view the yield as the base for returns in fixed income, but in this scenario, an investor could see price appreciation on top of the yield.

History indicates a favorable outlook for municipal bonds as the Fed takes action in 2024.

Investors seeking exposure to municipal bonds can diversify within the asset class by geography, maturity, coupon level, and issuer (state, city, county). Additionally, by using a disciplined investment process, investors can take advantage of weakness in the markets to add to attractive investments at cheaper prices.

The market continues to show volatility amid persistent inflation, a U.S. election cycle, and expected Fed easing. While we believe munis can play a key role in a diversified portfolio, an active approach is necessary to navigate shifting conditions ahead.