Higher municipal bond yields point to a compelling opportunity

Fixed-income investors have taken the U.S. Federal Reserve’s (Fed’s) aggressive tightening stance at face value and readjusted yields across the U.S. Treasury yield curve accordingly. The Treasury market is now pricing in 250 basis points (bps) of total rate hike movements over the course of 2022 with only 75bps on the books so far through May.¹

In our view, year-over-year inflation rates may have peaked in April, and the Fed may cause economic damage if it does tighten as aggressively as the bond market is anticipating. Any deceleration in the pace of Fed tightening would suggest that bond investors have overextrapolated the trajectory of rate hikes and that bond yields could actually fall as the year goes on.

Higher yields have made municipal bonds increasingly attractive

Municipal bonds, like the rest of the fixed-income market, have experienced meaningful volatility to start the year against this backdrop of repricing interest-rate risk. Like the Treasury market, municipal bonds have seen a similar upward yield movement and, in our view, this backup in yields offers income investors an attractive entry point.

In our most recent edition of Market Intelligence, we review how the starting yield-to-maturity of high-quality bonds tends to explain nearly 90% of subsequent five-year total returns.² The 10-year AAA S&P municipal bond yield was a meager 1.04% to start 2022, but has more than doubled over the past four months to 2.81%. To replicate this yield in the taxable bond market, an investor would need a bond yielding 4.46%. (at a 37% federal tax rate).

Fundamentals in the municipal market look positive

We believe municipal bonds are particularly attractive at these yields given the higher-quality nature of the market. In our view, municipality fundamentals have improved since the pandemic; state government tax revenues are historically high and have increased nearly $200 billion in 2021 compared to 2020.³ There is also federal aid in the mix: The Coronavirus State and Local Fiscal Recovery Funds program, a part of the American Rescue Plan, is set to deliver $350 billion to state, local, and tribal governments across the country.⁴ Overall, municipalities are in significantly better shape now than they were two years ago and also offer meaningfully higher yields than just a few months prior—two features we believe will make the asset class increasingly attractive for investors as the year progresses.

Higher-quality bonds can offer a defensive tilt as economic growth slows

As we discuss in Market Intelligence, we see U.S. leading economic indicators decelerating over the course of 2022. Although investors have been pulling assets out of fixed-income allocations (based on Morningstar flow data), we believe now may be the time to begin leaning into higher-quality bond allocations. As economic growth slows, higher-quality bonds offer less credit and default risk. In the case of municipals, investors get the added benefits of tax-advantaged income. To us, that makes for a compelling combination of features for investors given today’s volatile market.

Sources: 1 CME Group, as of 5/13/22. 2 FactSet, as of 4/30/22. 3 Bureau of Economic Analysis, as of 5/13/22. 4 U.S. Department of the Treasury, as of 5/13/22.