Things can only get better for the municipal bond market, headlines blare, but for even-keeled investors, the good times have already arrived.
They’re savoring juicy yields rarely seen in recent years.
Consider that for investors in the 40.8% tax rate, the taxable equivalent yield of 30-year, AAA-rated municipal bonds recently stood at a stellar 5.06%, or 163% of Treasuries.
Muni investors are not just reaping income free from federal taxes. They’re also doing so at a significantly higher yield than taxable equivalents.
Yields have changed the equation
Consequently, investors of all stripes are flocking to munis.
Traditionally, most were retirees who held bonds in their taxable accounts, where they could take advantage of the tax-free nature of municipal bonds.
Recent yields, however, have changed the equation. We’re seeing retirees and non-retirees attracted by the plump yields, and many even buy bonds in their qualified accounts.
What prompted the headlines
When the Federal Reserve stated its determination to raise interest rates, yields took off. Many investors, fearing inflation and a drop in bond prices, headed for the exits.
In the first half of this year, investors pulled about $75 billion from muni funds tracked by Morningstar. This was in sharp contrast to the first six months of 2021, when there was approximately $62 billion of inflows.
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As we have noted, however, the Fed influences only very short-term interest rates, which in turn slows the economy. Though we don’t pretend to know the future, history tells us that long-term yields, of most concern to municipal investors, ultimately decline (“A Closer Look at a Dubious Assumption”).
“One of the things we see frequently in municipal markets is a herding effect and people chasing returns on the upside and then, on the downside, saying, ‘Oh, no, I better get out,’” said Paul Malloy, of Vanguard, according to the New York Times.
“That kind of market timing is something we constantly warn municipal investors against.”
Lost on fleeing investors was the fact that credit quality wasn’t an issue with the bonds declining in market value.
Further, states didn’t face the level of challenges many feared as a result of Covid. In fact, collectively, during fiscal 2021, they grew their rainy-day funds to an all-time high.
Steady investors know the drill
Steady investors of individual bonds have seen this scenario before: Something other than the underlying strength of their securities affects their market value. They don’t lose sleep because they understand the bonds they buy.
Their focus is on perpetuating their steady flow of tax-free income and are in a position to capitalize on unique opportunities when they arise.
Meanwhile, the herd that moved on is missing the pastures they just left.
