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According to the Bond Buyer, “September municipal bond issuance declined 43% year-over-year, with nearly every structure and sector seeing large drops, as issuers eschewed the market amid another Federal Reserve rate hike and severe global market volatility.”1 Municipal bonds sold off in sympathy with Treasuries and as a consequence, yields increased to the highest level of the year.
Historical Municipal and Treasury Yield Movements
With AAA-rated Muni yields crossing above the comparable Treasury yield, there are compelling reasons to invest in highly-rated municipals. Remember, most interest received from municipal bonds is federally (and sometimes state) tax-exempt, while the interest paid on Treasuries is taxable. If an investor is in a high tax bracket, municipals are starting to look very attractive. For example, if you are in a 30% tax bracket and invest in a 30-year AAA-rated municipal yielding 3.90%, you would need an equivalent taxable yield of 5.57% (0.0390/(1-0.30)=0.557 or 5.57%) to be indifferent between the two securities. Based on the chart above, it is clear that it would be more advantageous to purchase municipal bonds versus purchasing 30-year Treasuries yielding 3.78%, significantly below the 5.57% equivalent taxable yield required if you are in a 30% tax bracket.
Another interesting feature to note from the chart above, we see that the Treasury yield curve is inverted. An inverted yield curve occurs when yields on longer maturities are lower than yields on shorter maturities. Historically, this has been a telltale sign of an impending recession. Further note that the municipal yield curve is not inverted, nor has it ever been. Why? In regards to the municipal market, the short end is perennially “rich” — that is, high in price and thus low in terms of yield. That reflects the persistent supply-demand mismatch, as the lion’s share of municipal bond issuance comes from the long end of the maturity curve in the municipal market. As a result, short-term municipals are most advantageous to those in the highest tax brackets, while farther out the yield curve, the tax-exempt status pays off for those in lower brackets.
With the real threat of a recession in 2023, credit analysis of municipals will once again be very important as the market changes. One must look at the macro factors that affect the municipal issuer including demographics, wage growth and unemployment trends. Let’s review the two largest types of municipal bonds — GOs and Revenue Bonds.
- Local General Obligation (GO) bonds are backed primarily by property taxes. Property taxes are based on the current assessed value of the home (except in California with Proposition 13). As mortgage rates increase, the value of homes may decrease—potentially lowering the tax base of the municipality.
- Revenue Bonds are backed by a specific revenue source—revenues from a specific project or a dedicated stream of sales taxes. For example, many shopping malls have issued revenue bonds. How will they do if the retail sector falters due to inflationary pressures and the risk of recession?
With rates at near zero for many years, the current rising interest rate environment will require more due diligence—not only in the municipal market but the corporate market as well.
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1 Bond Buyer – September 30, 2022
