What are the benefits and risks of investing in municipal bonds and how are they performing?
Bonds can have their place within a diversified portfolio of investments as they are generally less risky than stocks, tend to have lower price fluctuations, as well as providing a steady income stream from the interest payments. We often hear about Treasury and Corporate bonds, but here let’s consider Municipal bonds.
If you invest in municipal bonds, you are lending to state and federal governments so they can spend on public works like airports, roads, hospitals. Interest income from most municipal bond issuance is exempt from federal tax and may also be exempt from state income tax if you live in the state which is issuing the bond. Remember though that the tax benefits only apply to interest income, not any capital gains if you sell the security.
The 3 ways you can invest in municipal bonds: new issuance, secondary market or muni bond fund, such as a mutual fund or ETF. New issuance is for new projects being financed, whereas secondary market is for buying bonds previously issued or selling bonds you hold which have not yet matured. Funds invest in a variety of muni bonds, to which you can get exposure by buying a portion of the fund.
Be aware of interest rate risk if investing in muni bonds. If the interest rates rise after you purchase a muni bond, newer issuances with similar terms and structures may offer a higher yield and you may get a lower price if you sell your muni bond.
Credit risk is also a factor to consider and each issuing state/municipality is given a credit rating by the 3 major agencies (Moody’s, S&P, Fitch) so guide in assessing credit and default risk. Although generally lower risk than corporate bonds, muni bond defaults are not unheard of (eg Puerto Rico in 2016).
One way to understand movements in the muni bond market is by looking at the municipals-over-bonds (MOB) spread, which is the relationship between a muni bond yield and the yield of a treasury bond with similar maturity. When muni bond spreads are rising faster than treasury spreads, the MOB spread widens.
2020, amidst the COVID-19 pandemic, has been a volatile time for muni bonds. In March, the 10-year MOB spread surged to its highest rate since the 2008 credit crisis. Liquidity receded as investors withdrew from muni funds, amidst credit concerns. The economic impact of the pandemic caused investors to be cautious about the risk of default from states and municipalities. More recently in 2Q 2020, we have seen the Muni bond market rebound as the Fed has cut Fed Funds rate and launched bond purchase programs which include municipal bonds. In July supply of new issued bonds increased 31% above the 5 year average and similarly there was strong demand to absorb the new supply.
Given this recent performance, and with supportive supply and demand fundamentals, the muni market feels relatively attractive in the near future. However, considerable uncertainty surrounds the economic effects of the pandemic, alongside the presidential election, which could cause further volatility, particularly for bonds financing projects related to senior living/long term care facilities, hospitals and hospitality and travel.