Municipal bonds are an excellent method to keep your money safe while earning interest. The majority of them are tax-free at the federal level, and several are also tax-free at the state and local levels.
Is it wise to invest in municipal bonds?
Municipal or corporate bonds are a wonderful option for investors looking to build a steady stream of income, especially during retirement. Highly-rated bonds are, by definition, extremely safe investments when compared to practically any other option, particularly stocks.
What are some of the reasons why someone would buy a municipal bond?
Municipal bonds can be a good investment for conservative, income-oriented investors because the interest income is often tax-free on both the federal and state level.
Is it wise to invest in municipal bonds in 2022?
The key drivers of the municipal market are all positive, therefore 2022 is expected to see ongoing robust demand for municipal bonds. Taxes are first and foremost. Investors are still concerned about increasing taxes and will do everything possible to avoid them, keeping demand high.
What is the typical return on tax-exempt municipal bonds?
The top five municipal bond funds are ranked by their one-year trailing total return (TTM) as of the market close on December 10, 2021. The funds were chosen from a collection of funds that are open to new investors, need a $1,000 minimum initial investment, and have at least $50 million in assets under management (AUM). The first four funds are all Morningstar-rated “Over the last year, the “High Yield Muni” category has averaged a total return of 6.0 percent. The last fund is owned by the “Muni National Intermediate” with a total return of 1.9 percent throughout the same time period.
Opportunity cost
Municipal bonds’ tax advantages aren’t as valuable if you’re in a lower tax band as they are if you’re in a higher tax bracket.
If that’s the case, you could be better off putting your money into alternative investments for a larger return.
They may not be liquid
If you need money quickly, you should be aware that municipal bonds may have liquidity problems.
You might not be able to find an active market for your bonds, which means you won’t be able to sell them when you want at the price you want.
What are the dangers of municipal bonds?
- Municipal bonds are a wonderful option for consumers who want to keep their money while earning tax-free income.
- General obligation bonds are used to quickly raise funds to meet expenses, whereas revenue bonds are used to fund infrastructure projects.
- Both general obligation and revenue bonds are tax-free and low-risk investments, with issuers who are quite likely to repay their loans.
- Municipal bonds are low-risk investments, but they are not risk-free because the issuer may fail to make agreed-upon interest payments or be unable to repay the principal at maturity.
What are the advantages and disadvantages of purchasing a municipal bond?
The most significant benefit of municipal bonds is that they are tax-free. Municipal bond interest rates may appear low when compared to equivalent long-term instruments such as Treasury bills and CDs, but tax benefits may level the playing field. Let’s have a look at a few examples.
To match the yield of a tax-free municipal bond with an interest rate of 3% if you’re in the 25% tax bracket for 2008 federal income taxes, you’d have to locate a taxable asset with a 4% interest rate. To put it another way, if you have $5,000 to invest in a bond, a 3-percent tax-free bond will earn you the same amount as a 4-percent taxable bond.
Are municipal bonds susceptible to depreciation?
Municipal bonds or money market funds will give you interest if you want to invest for income. Just keep in mind that bonds can lose value, whereas money market funds are unlikely to. It’s also worth noting that, because municipal bonds are tax-free, you’re making more money than the interest rate suggests. You can deduct your tax savings when calculating the value of such a bond.
Why are municipal bonds in decline?
Some economists predict a reduction in muni demand this year due to a predicted slowing in household savings, which grew during the pandemic, particularly among the wealthy. The demand for tax-exempt debt has long outstripped annual issuance.
How are municipal bonds faring?
In terms of performance, new issuance, and investor demand, the municipal bond market had a strong year. This achievement is all the more remarkable given that it occurred at a time when inflation was rising, interest rates were rising, and the epidemic was still going strong.
On the technical side, new issuance increased by about 15% in 2021, reaching a new high of $316 billion. Furthermore, fund flows were positive in 51 of 52 weeks, reaching more than $100 billion, a new high. As a result, the supply of fresh issues was rapidly consumed, and oversubscriptions were common.
Since mid-2020, the fundamental credit quality of municipalities has been improving. Municipal issuers, such as state and local governments, airports, public transit systems, hospitals, and schools, received $1.25 trillion in the four key stimulus acts. Furthermore, state government revenues have more than recovered, increasing by 21% and coming in 19% higher than pre-pandemic levels. Only 30 downgrades were given by Moody’s in the third quarter, compared to 115 upgrades.
In comparison to other fixed income asset classes, high quality municipals performed consistently in 2021, with minimal volatility and less interest rate sensitivity. Munis have only displayed 32% of the volatility of US Treasury bonds in the 30-year area of the yield curve, and only 22% in the 5-year segment. For the year, the S&P Main Index (AA-range average credit quality) returned 1.77 percent.
Credit spreads narrowed by 80 basis points over the equivalent-maturity AAA bond this year, from 265 to 185 basis points. This resulted in high yield outperforming investment grade by a significant margin. In 2021, the S&P Municipal High Yield Index returned 6.82 percent, outperforming the market by more than 500 basis points. BBB spreads fell from 108 basis points to 63 basis points in 2021, indicating a narrowing of lower investment grade spreads.
Municipal-to-Treasury yield ratios are still low by historical standards. The 10-year municipal-to-Treasury yield ratio started the year at 76 percent, matching its historical average, but fell to 68 percent at year’s conclusion. Although this is a long way from its tightest levels in 2021, it still demonstrates the asset class’s resilience in this portion of the curve. 30-year ratios, which are normally less expensive than 10-year ratios, fell to 78 percent at the end of the year, compared to a long-term average of 93 percent.
The supply of new issues fell marginally from 2020 to $358 billion, but the composition was very different. Refinancings fell by 24 percent, but new capital issuance increased by approximately 15 percent to $316 billion.
Taxable municipal supply fell by 20% for the year, but it is still a far larger part of the total market than it was before the Tax Cuts and Jobs Act of 2017. Taxable munis accounted for 30% of the new issue market, with over $140 billion in new issuance.
In terms of fresh issuance in 2022, there is a lot of uncertainty. For both tax-exempt and taxable municipal borrowers, interest rates and spreads are now attractive. If rates rise rapidly, though, this attractiveness will alter. Furthermore, because state and local governments are flush with federal stimulus funds and record revenue receipts, projects might be funded without incurring new debt. Rising rates, on the other hand, may not deter issuance because infrastructure improvements need significant money, and increased revenues provide borrowers confidence to take on new debt.
Forecasts for new issuance in 2022 range from $400 billion to $520 billion, with a median of $470 billion. Moderate growth from last year’s level appears to be the most likely scenario.
In 2021, municipal mutual fund flows were constantly positive, with investor demand increasing 51 times out of 52 weeks. In October, November, and December, open-end mutual funds received $1.94 billion, $4.84 billion, and $2.34 billion, respectively. The annual total was roughly $71 billion through November. Municipal exchange-traded funds increased at a quicker rate than mutual funds on a percentage basis, hence this total understates interest in the asset class.
In October, November, and December, high yield municipal fund flows were -$264,000, +$2.60 million, and +$2.28 million, respectively. Annual fund flows were also strong in November, totaling roughly $20 billion.
Payment defaults totaled $2.1 billion in 2021, down 19 percent from the previous year. This is still a relatively modest portion of the $4 trillion market. Nursing homes and revenue bonds for industrial development continue to account for over 75% of all municipal defaults in 2021. Prior to the pandemic, these groups contained among of the most idiosyncratic risks in the municipal market, and they accounted for a large share of overall new defaults. In most cases, the defaults cannot be explicitly linked to pandemic consequences, however this may change in the future. We do not believe that municipal payment defaults will become prevalent.
Outlook
The municipal bond market, like the rest of fixed income, is facing headwinds. With a tighter labor market and stubborn inflation, the Fed may be able to accelerate the end of QE and start raising rates sooner than expected. Furthermore, fiscal stimulus should be reduced drastically.
- The US economy is doing well on its own, which means less monetary and fiscal assistance is required. The federal deficit in the United States has been drastically reduced as a result of this normalization process compared to the previous year.
- Municipal cash and revenue levels are at all-time highs, with credit trends in most sectors going in the right direction.
- Demand for both taxable and tax-exempt municipals is outstripping new supply, indicating that liquidity is strong.
- Potential new federal government initiatives that could have an impact on the municipal market have seen a significant decrease in volatility.
Overall, we think it’s a good idea to take advantage of the upward momentum in municipal credit, which has had little association with Treasury rate movements. We would see this as a chance to buy into weakness and higher yields if Treasury market volatility has a negative influence on municipals at key periods this year.
- Although the Federal Reserve is focused on controlling inflation, the course of inflation will be a wild card in 2022.
- The Federal Reserve has expedited the pace of tapering in order to end it earlier in 2022, and it has hinted at a first rate hike as early as March. This year, there could be as many as four rate hikes, with more hikes predicted until 2024.
- Although the economy has reached its peak, growth remains strong as the economy returns to normalcy.
- The $1.2 trillion Infrastructure Bill was passed in late 2021 with some cuts. More fiscal stimulus is possible, although at a far lesser level than in the previous two years.
- The net supply of tax-exempt municipals may be restricted, but demand has easily absorbed supply. The taxable municipal supply is expected to be strong, following the same trajectory as in 2021.
- Municipal credit has rebounded strongly since the downturn, bolstered by greater tax receipts and trillions of dollars in federal assistance.
- COVID-19 and its variants can have an influence on global growth, while outbreaks in the United States are less likely to trigger widespread shutdowns or have a negative impact on municipal credit.
- We predict high yield municipal bonds to continue to outperform in 2022, despite variable interest rates and robust credit conditions.