Ever wonder how municipal bond investors sleep peacefully at night when the fiscal ride gets bumpy in Washington?

Consider the federal government’s responsibilities – along with persistent gridlock, deficits and periodic credit downgrades. It’s easy to assume that stress in Washington inevitably spills over into municipal bonds.

But a closer look suggests otherwise.

“Municipal bonds – issued primarily by states and cities – bring something different to the table,” notes Kiplinger in a recent article. “They’re secured by independent government revenue streams and local financial strength, offering investors steady income and a way to help maintain stability when conditions shift at the federal level.”

This distinction is important.

States are required to balance their budgets. Many municipal issuers rely on dedicated revenue pledges, such as property taxes, sales taxes or utility payments, which are legally committed to bondholders. Their credit strength is tied primarily to local economic conditions, not federal borrowing levels.

Recent history highlights the difference.

Munis a ‘steadying force’

In August 2023, Fitch downgraded U.S. sovereign debt, a move The Bond Buyer reported was expected to have little impact on the broader municipal market. As it turned out, muni and 10-year Treasury yields rose approximately 50 basis points over the following two months but rebounded by the end of the year, the publication later reported.

Similarly, when Moody’s downgraded the U.S. credit rating to Aa1 from AAA last May, municipals weakened only slightly, with market participants noting “little fallout” in the wake of the announcement.

In both instances, the municipal market held steady despite the sovereign downgrade headlines.

That does not mean that what happens in Washington is irrelevant, but history suggests the relationship is often less direct than headlines imply.

Context matters

Federal fiscal events do not automatically translate into municipal credit stress. One common assumption, for example, is that rising federal deficits presage municipal credit risk.

But as Kiplinger observed, “State and local governments aren’t responsible for federal obligations, and their ability to meet debt service depends on local economic conditions.”

That distinction is easily overlooked during periods of national fiscal anxiety.

In addition to their reliable stream of tax-free income, tax-exempt bonds can also provide meaningful diversification.

“When markets react to fiscal headlines or economic uncertainty, municipal credit quality doesn’t automatically follow. Most muni issuers maintain strong balance sheets and conservative debt practices, making municipal bonds a steadying force,” Kiplinger said.

Source of diversification

We’ve always maintained that with careful selection, municipal bonds are simple securities, yet misconceptions persist.

Whether the concern centers on yields (“How Perception is Driving Muni Yields”), stock market volatility (“When Sellers Present Buyers with a Muni Opportunity”), pandemic fallout (“Coronavirus Fallout and the Municipal Bond Market”) or a host of other fear-fueled headlines, short-term anxiety can overshadow fundamentals.

Diversification can be especially valuable during periods of policy and market volatility.

For buy-and-hold investors seeking attractive income, today’s environment continues to present opportunity, particularly in the long end of the curve, where yields remain compelling.

Federal turbulence may dominate the news cycle. But well-selected municipal bonds remain grounded in local revenue, disciplined budgeting and identifiable sources of repayment, characteristics that have historically allowed investors to rest a little easier, even when Washington cannot.