Investment Strategy

Municipal bonds are in the spotlight. Should they be in your portfolio?

Nov 15, 2022

With tax-equivalent yields around 7% and strong fundamentals, municipal bonds are one of our highest-conviction ideas.

Paul Jacobson, Municipal Credit Analyst

Chris Seter, Fixed Income Strategist

 

This material is intended for U.S. investors only.

If you own municipal bonds, you’re likely well aware that they’ve had a tough year, as the Federal Reserve has hiked interest rates sharply. Rising interest rates negatively impact the price of bonds, including muni bonds; this prompts many investors to sell, which puts further pressure on bond prices.

But now it gets interesting. As prices declined, yields on muni bonds rose to their highest levels in more than a decade. They’re currently higher than most other bond yields and close to annualized long-term equity returns.

What’s more, while bonds with higher yields typically require investors to accept a higher risk of default, most municipalities currently have extremely strong financial positions, which should translate to a relatively lower risk.

That adds up to a compelling risk/return opportunity in municipal bonds. Let’s take a closer look.

High yields for a high-quality asset class

The Bloomberg Municipal Bond Index declined 12.5% this year through November 7—one of the worst-performing years in history. But its yield has risen from 1% to almost 4%.

More importantly, the tax-equivalent yield (the higher yield that a taxable bond would need to equal that of a tax-exempt muni bond) has risen to 7%—the highest level in over a decade.

This means muni bonds are outperforming the 4% yield for Treasuries and 6% yield for the JULI Investment Grade Corporate Index. They are even topping the close to 6.5% annualized return for the S&P 500 Index since 2000.

Muni bonds also look attractive compared to Treasuries when expressed as a yield ratio using same-maturity Treasuries.

Muni bond yields are now higher than most bond yields

Source: Bloomberg Finance L.P. Data as of October 27, 2022. TEY = tax-equivalent yield. 
Chart compares yields for broad fixed income sectors from start of 2022 to today.

Muni fundamentals are the strongest in decades

To get high yields, you typically have to take more risk. For example, the only major U.S. fixed income asset class yielding more than muni bonds is high yield, where issuers are rated below investment grade because they have a higher risk of default.

But here’s the good news: Muni bonds not only offer high yields now, they also are a higher-quality asset class. Roughly 85% of the market is rated A or higher.

And current fundamentals are in particularly good shape. Boosted from federal fiscal and monetary policy support during the pandemic, municipal revenues have surprised to the upside in the past two years.

One result is that many state and local jurisdictions have been able to bolster their “rainy day” funds, provide tax relief, pay down debt or make supplemental pension payments.

In 2022, the public finance system continues to be awash in liquidity, benefiting from federal government–funded relief, including the Coronavirus Aid, Relief and Economic Security (CARES) Act and the American Rescue Plan Act (ARPA), among others.

At the same time, home prices and wages have continued to rise, lifting municipalities’ revenues from property taxes and wages. Tax receipts are up 18.2% this year, on average, in the 40 states that provided tax data through July.

This exceptionally strong financial position means that most muni bond issuers are unlikely to default on their payments, even if the economy goes into a recession and causes municipal revenues to decline.

Taxes are flowing into municipalities’ coffers

Sources: Individual state monthly tax reports, J.P. Morgan. Data as of September 7, 2022. Note: Oregon, Wyoming and Alaska do not provide monthly tax data. Bars in gray indicate July data is not yet available and the year-to-date period has been adjusted. Indices are not investment products and may not be considered for investment. Past performance is not a guarantee of future results.
Chart shows the year-to-date percent change in tax revenue in 2022 relative to 2021. YTD revenues are up by at least 10% in the majority of states.

How might municipal bonds fit in your portfolio?

While rate volatility could remain elevated in the short term, muni bond’s higher yield now provides an enhanced buffer against further price declines should interest rates continue to rise.  

Muni bonds also might be helpful in a portfolio in the opposite scenario: If the economy goes into recession and interest rates decline, muni bond prices would appreciate (essentially the opposite of what has been happening)—which could boost total muni bond returns at a time when equity returns may be lower.

We believe muni bonds now offer outstanding value for investors seeking to extend duration in fixed income portfolios and to lock in elevated yields for a multi-year period. Investors have options for implementation.

  • In a bond ladder, a Separately Managed Account is used to purchase a portfolio of bonds with different maturities. Ladders typically include high grade issues with credit ratings of A or AA and exposure to core sectors (such as General Obligation bonds and/or large revenue bond issuers).
  • Investors looking to get into fixed income more broadly could also benefit from active solutions that have a meaningful allocation to muni bonds, along with the flexibility to invest in other areas of fixed income during times of market dislocation.
  • Lastly, those who want to focus on adding duration to their portfolios could consider longer-dated muni bonds with eight-to-10-year calls to gain duration exposure and lock in yields over the long term.

Your J.P. Morgan team can help you evaluate which opportunities in municipal bonds might help you achieve your long-term goals. You also can learn more about investing in fixed income here.

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Important Information

Investors should understand the potential tax liabilities surrounding a municipal bond purchase. Certain municipal bonds are federally taxed if the holder is subject to alternative minimum tax. Capital gains, if any, are federally taxable. The investor should note that the income from tax-free municipal bond funds may be subject to state and local taxation and the Alternative Minimum Tax (AMT).​

The Bloomberg Municipal Bond Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.

The JPM Investment Grade Index (JULI) provides performance comparisons and valuation metrics across a carefully defined universe of investment grade corporate bonds, tracking individual issuers, sectors and sub-sectors by their various ratings and maturities.

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

Investing in fixed income products is subject to certain risks, including interest rate, credit, inflation, call, prepayment, and reinvestment risk.

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