The Federal Reserve dominated financial headlines this week as the new chairman presided over his first policy meeting.

As it turned out, the central bank unanimously voted to keep rates steady, where they’ve been since late last year.

Although the spotlight has been on the latest clues about the future path of short-term interest rates – the Fed’s domain – an important reality for municipal bond investors has received far less attention: The municipal yield curve is still steep, and tax-free yields are compelling.

That is, investors are currently receiving a larger-than-normal increase in yield for extending maturities.

Shifting curve

At the beginning of the year, we noted that the municipal yield curve had begun flattening from unusually steep levels (“How Perception is Driving Muni Yields”).

However, early this quarter, the difference between yields on high-quality five-year and 20-year municipal bonds widened to more than 145 basis points, levels rarely seen over the past 15 years, according to Nuveen.

Although the gap has narrowed somewhat since then, municipal bond investors, who focus on the long end of the curve, can still earn substantially higher tax-free yields than those available in intermediate maturities.

While the shape of the curve continues to shift, the opportunities available in longer maturities remains remarkable.

Solid fundamentals

Why does that matter?

Because higher long-term municipal bond yields can translate into exceptional levels of tax-free income for those willing to commit capital for longer periods.

For investors in higher federal tax brackets, the advantage becomes even more pronounced. Recently, the tax-equivalent yield of 30-year, A-rated bonds was a whopping 8.47% for those paying the 40.8% tax rate, for example. Residents with state income taxes can expect to receive an even greater benefit.

Importantly, many municipal issuers continue to report healthy reserves and manageable debt levels. That combination of solid fundamentals and elevated yields helps explain why investors continue to flock to municipal bonds.

Equally important, there’s no need to predict the future direction of interest rates to appreciate the opportunity. Yields available in the municipal market would have been difficult to find just a few years ago, while the additional compensation available for moving further out on the curve remains unusually lucrative by historical standards.

As always, bond selection remains important. Credit quality, maturity, call features and overall portfolio objectives should all be considered when evaluating municipal bonds.

The current shape of the municipal yield curve offers a reminder that opportunities sometimes emerge when market conditions become unusual, and today’s municipal market is providing one of those moments.