With the Federal Reserve raising interest rates to combat inflation, 2022 presents a challenging environment for many fixed income investments. However, municipal bonds may offer a bright spot for investors seeking tax-free income. In today’s rising rate environment, municipal bonds can provide attractive tax-equivalent yields compared to taxable bonds. Investors should consider factors like credit quality, duration risk, call provisions, and liquidity when evaluating muni bonds. Although defaults remain historically low, due diligence is still required on issuers. On a total return basis, municipal bonds may lag other fixed income sectors in 2022, but their tax-exempt income can make them a worthwhile component of a diversified portfolio.
Tax-exempt income becomes more valuable as tax rates rise
The key advantage of municipal bonds is their tax-exempt interest payments. For investors in higher tax brackets, this tax exemption becomes increasingly valuable as federal income tax rates rise. While the Biden administration has proposed increasing the top marginal tax rate to 39.6%, it remains to be seen if Congress will approve this measure. However, state income taxes still apply for most investors. When you combine federal and state taxes, the marginal tax rate for top bracket taxpayers can exceed 40% in some areas. This makes the tax-free income from municipal bonds very attractive on an after-tax basis compared to taxable bonds. For example, a 2.5% yielding municipal bond would equate to over a 4% taxable equivalent yield for an investor in the 32% bracket.
Municipal credit quality remains strong despite economic uncertainty
Despite rising recession concerns, municipal defaults remain quite rare historically. According to Moody’s data, the average annual default rate from 1970 to 2020 was just 0.10% for investment grade municipal bonds. The Covid-19 pandemic did not result in a spike in defaults either. Strong household balance sheets, solid property valuations, and federal stimulus helped most state and local governments avoid financial calamity. Looking ahead, high revenue collection and healthy reserves should help municipal issuers weather a potential economic downturn. However, it is still prudent for investors to analyze the underlying credit fundamentals of individual issuers. Factors like pension funding levels, infrastructure investment needs, and reliance on economically sensitive revenues warrant close scrutiny.
Duration risk and call provisions require careful consideration
With the Fed tightening monetary policy, duration risk is elevated for all longer-term fixed income securities. Municipal bonds with longer maturities will see their prices fall more than short-term bonds when interest rates rise. Investors concerned about rising rates may want to keep their municipal bond durations relatively short. It is also important to evaluate call provisions which allow issuers to repay bonds early. Municipal bonds are often callable after 10 years. So investors in longer maturity bonds face reinvestment risk if rates are lower when bonds are called. Using callable municipal bond ETFs or mutual funds can help manage call risk.
Liquidity varies across municipal bond market sectors
While the municipal bond market is quite large, liquidity is not uniform across sectors. General obligation and essential service revenue bonds tend to be the most actively traded. Small issuance sizes can negatively impact liquidity in some cases. Securities issued for narrow purposes like housing or hospitals may not trade frequently. This is important to consider for investors who may need to sell municipal bond holdings in the near term. Using broadly diversified municipal bond mutual funds and ETFs can help augment liquidity for individual investors.
Total returns may lag in 2022, but income remains attractive
On a total return basis inclusive of price changes, municipal bonds may underperform US Treasuries and corporate bonds this year. Rising rates tend to disproportionately pressure prices of longer-duration municipal bonds. However, investors focused on generating tax-free income may still find municipal bonds an appealing component of their portfolio in 2022. When factoring in taxable equivalent yields, high quality municipal bonds look attractive versus other fixed income sectors in the current environment. Diversification and prudent credit analysis remain as important as ever for municipal bond investors.
Municipal bonds can provide an oasis of tax-exempt income for investors in 2022 and beyond. Their tax-advantaged status becomes more pronounced as tax rates trend higher. Maintaining rigorous credit analysis, managing duration, understanding liquidity dynamics, and using low-cost broad market municipal bond funds can help investors optimize their experience.