The screaming banner headline running across the Goldman Sachs Asset Management “Muni Monthly” newsletter for January was hard to miss: “WHAT A START! BEST JANUARY IN 14 YEARS!”
Given the pounding that municipal bonds took for most of last year and the stellar turnaround taking place now, asset managers can be forgiven for wanting to shout the good word from the rooftops.
The S&P Municipal Bond Index showed a 3.21% return for January, the highest monthly return since 2009. For those who need reminding, that’s tax-free at the federal level, and sometimes at the state and local levels, too, making this investment extremely attractive to tax-sensitive (read: high-net-worth) clients. The taxable equivalent would be 4.9% for someone in a 35% tax bracket (using the formula of dividing the return percentage by one minus the tax bracket percentage) and with very low risk.
Ask Kevin Knowles, a senior director of personalized solutions and direct indexing at Russell Investments in New York, and he’ll say that, while extremely favorable yields are driving 2023’s surge, the tax-efficiency of municipal bonds has been luring a growing fan base for a while. “Everyone used to be focused on pretax returns, and now it seems like there’s been a shift to focusing on the actual after-tax return,” he says. “I don’t know what happened behaviorally within the advisor universe that made them say, ‘Oh, wow, we should actually be looking at what the investors are keeping as opposed to what they’re making on paper with that pretax return.’ Because if a lot of that is distributed in capital gains at the end of the year, you pay taxes on it and that just puts a drag on your portfolio for … forever.”
Now that municipal bond yields are close to record highs and sources say they are predicting a good year ahead, there are three primary reasons it’s time for financial advisors to revisit their municipal bond allocations.
Those Juicy Tax-Exempt Yields
Back in October, municipal bond yields were as high as they’d been in the last 13 years, hitting a yield of 4.423%, the taxable equivalent of 6.8%. And even with a slight pullback, at the time this article went to press they were still at 3.712%, close to all of the other high points over the last decade, according to the S&P Municipal Bond Index.
Considering they started 2022 at around 1%, that is quite a feat, sources say. “After a fairly disastrous year for fixed income in 2022, the last four to five weeks have been very refreshing from a return perspective. Rates across the board increased, but for munis specifically we saw rates move up anywhere from 150 to 200 basis points across the curve,” says Nisha Patel, a managing director at Parametric in New York in charge of portfolio construction and risk management for the tax-advantaged bond strategies group.
The Fed’s aggressive interest rate policy and the associated bump for U.S. Treasury rates has a trickle-down effect for municipal bonds, albeit with a bit of a lag. But the current buoyancy in the muni market has only partly to do with that, she says. A selloff in munis earlier last year was hard to watch, but it paved the way for some of the gains now.
“Last year, almost $120 billion was pulled out of muni mutual funds, which is a lot. I think about 4% to 5% of the entire market. It’s a phenomenon that occurs in a retail-dominated market where clients start seeing red on their statements and start pulling money,” she says.
The selloff was entirely related to the Fed’s interest rate hikes, she says, and had nothing to do with credit quality, which is very high. When outflows like that occur, municipal bond yields have to become more and more enticing to attract buyers, which results in some very good news for investors.
“They start getting very attractive relative to Treasury yields,” she says. “All of a sudden that muni-to-Treasury ratio starts getting extremely cheap, and you start looking at 10-year tax-free yields at 3.75%, the taxable equivalent of about 6%, which is pretty juicy, and you start to have money coming back in.”
That tax-free status not only resonates strongly with high-net-worth clients, it also translates through time to much bigger gains beyond the immediate yield. “The most important point about municipal bonds is that they’re tax-free and compounded, and if it’s reinvested over and over, that’s great for the client,” says Michael Pidhirskyj, a CFA and director of fixed income at Pitcairn in Jenkintown, Pa. “Those end up being huge gains.”
Outstanding Credit Quality
Thanks to the federal aid throughout the Covid crisis and an anticipated pandemic downturn that proved short-lived, municipalities are in great fiscal shape, sources say.
“State and local government revenues are up quite substantially,” says Cooper Howard, director and fixed-income strategist for the Schwab Center for Financial Research. “They’re at record highs if you look at things like corporate income taxes, property taxes, individual income taxes, payroll taxes; all are near record-level highs.”
Even if the U.S. slips into recession this year, it would take some time before a drop in tax revenue elevates municipal bond credit risk. “Oftentimes, taxes are based off lagging numbers,” Cooper says. “It takes about three years before a change in market value actually translates into a change in property tax levels for local governments. That long runway gives state and local governments pretty ample planning time to make adjustments if they need to.”
In addition, municipalities tend to have very few credit downgrades because revenue sources are so stable, he says.
Patel adds, “Multiple rounds of federal fiscal stimulus during the pandemic and the result of revenues exceeding forecasts have brought about a situation where most states and most issuers are two to three times better off from a liquidity standpoint going into this recession than they were going into 2008.
“In short,” she adds, “credit fundamentals in our view have never looked stronger.”
Some Commitment, But Not Too Much
Because of where yields lie right now, there’s no need to stay short with munis, but no need to go super-long, either, sources say.
Patel says she’s recommending a one- to 15-year ladder, and even “chopping off the first few years” would be fine. “We like the idea of adding duration in the context of it being a good way to lock in yields for an extended period of time. If yields fall, having duration will help from a performance standpoint,” she says.
For clients who want to stay short, Patel says the one-to-five-year window is still profitable, with a 2.20% yield and a taxable equivalent of about 4.75%. And while the one-year Treasury is yielding 4.85%, that’s just for one year, and the likelihood that in a year the rate will be the same is low, she says. “So lock in the higher yield today for an extended period of time,” she recommends.
Over at Schwab, Howard says he likes five-to-seven-year durations. “That’s where relative yields are most attractive. We also suggest clients extend duration a little bit because we’re seeing clients put in cash for very short-term investments, concerned about what the Fed is going to do. But we don’t think that’s the right strategy. We think it makes sense to take advantage of the move up in yields and lock in yields at these attractive levels.”
Pidhirskyj agrees. “Five, seven, 10—you want that medium, intermediate duration. You’ll get some positive potential returns if the Fed cuts rates,” he says. “I don’t think another 25 basis points are worth it on the front end. Even if you bet a fully steeper curve, the value would still be in the middle of the curve.”
And finally, a fourth, bonus reason to stay intermediate is that even though currently short-term durations are paying slightly more, historical performance goes all-in on intermediate lengths.
Historically, once the Fed stops raising interest rates, intermediate-term muni bonds perform a lot better than short-term options. On average, those intermediate durations paid more than 4% more in total return six months after the peak fed funds rate. For example, in December 2018, intermediate-term munis paid 3.6% better, returning 4.8% compared with 1.2% for short-term munis.
At a time when the Fed is cutting rates, that certainly would be something to shout about.