You may have heard a recession is just around the corner. Or the economy will soften a bit – though not crash – and continue to grow.
Like everyone else, we can’t predict the future. But as longtime municipal bond specialists, we know what the market is telling us.
Bond issuance is down
Since the beginning of the year, municipal bond issuance has dropped more than 25% compared with last year and is lower than the 10-year first-quarter average.
Key to the decline is fewer advance refunding bonds, which fell off by 45% year-over-year. Advance refunding bonds enable issuers to replace older, higher-interest rate bonds with newer bonds at lower rates. In the current environment, where borrowing costs have increased, issuers have less opportunity to refund.
Flight to safety
We also know muni yields are the highest in years. Depending on their tax bracket, investors can secure long-term taxable-equivalent yields of more than 6.00% in highly rated municipal bonds.
It’s why voices extolling the virtues of municipal bonds are getting louder as fears of a recession mount.
State and local governments look fiscally solid. Federal aid amid the pandemic, resilient growth and better-than-expected revenues have enabled states to replenish their rainy-day funds, solidify their financial footing and plan ahead for possible shortfalls (see “Strong States Behind the Municipal Bond Market”).
Everyone knows municipal bonds support the essentials, like water and sewer services and garbage collection. These are services citizens need regardless of how the economy is performing and is one reason municipal bond defaults are exceedingly rare.
An opportunity for capital gains
We also see – without having to tease out the future from conflicting information – an inverted yield curve, where shorter-term Treasury yields are higher than long-term yields. This is the predictable result of the Fed aggressively raising interest rates to try to tame inflation.
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We know that for decades, a recession usually follows this phenomenon.
Ultimately, a weakening economy brings down longer-term rates, which are the focus of municipal bond investors, and this is precisely what’s happening. While still highly attractive, muni yields are easing as the economy slows.
This, in turn, provides investors a unique opportunity. Although they buy munis for the tax-free income, the current environment enables investors to take advantage of the appreciation of their bonds.
That’s what we know.
Investors still have to do their homework. That’s always true. Aim for quality first, then yield.
Importantly, ignore the forecasters discussing headwinds and tailwinds, and hard and soft landings. Investors don’t need prognostications to capitalize on the facts we know and maintain their dependable stream of tax-free income.