Weaker returns on fixed income investments were a feature, not a bug, of the period following the global financial crisis. Global central banks held policy rates close to zero and exerted their wills on the longer end of yield curves to force investors into riskier assets, hoping to spur growth in the real economy.

It worked: Investors in U.S. stocks have reaped total returns of almost 400% since the depths of the financial crisis, while investors in municipal bonds have earned only about 50%. Given this glaring discrepancy in past performance, it might be difficult to get excited about municipal bonds as an asset class. However, we believe there are three reasons why it is time to revisit them:

1. Attractive tax-adjusted returns

2. Relative safety

3. Ability to dampen portfolio volatility

The interest paid on municipal bonds is usually exempt from federal income tax, and is often exempt from state and local taxes when the bondholder resides in the state that issued the debt. Now that there is a $10,000 cap on state and local tax deductions, sources of tax-exempt income have become even more important, especially for residents of high-tax states such as Connecticut, California or New York. Consider a triple A–rated N.Y. bond maturing in 2033 (approximately 7-year duration). You would have to buy a fully taxable bond at over 6% yield to get the same after-tax yield you would get from that muni. The only place where that is possible now is in high yield bonds.1

Municipal bonds have historically provided investors with some of the most attractive risk-adjusted returns of any major asset classes, even before accounting for their preferential tax treatment. Consider that less than one-half of 1% of all municipal bonds have defaulted from 1970 to 2017. The default rate on Baa-rated municipal bonds is 1.15%, compared with 3.76% for Baa-rated corporate bonds.2 While there are risks around the conflict between unfunded pension and healthcare obligation costs and debt service for some municipalities, we believe the foundation of the municipal bond market is still solid.

The combination of the two characteristics discussed above makes municipal bonds an invaluable addition to portfolios. As the later stages of the business cycle progress, we expect to see more volatility in riskier asset classes (such as equities and high yield). Because of their relative safety and attractive yields, municipal bonds could provide a stabilizing ballast to portfolios without sacrificing very much absolute return. In fact, over the next three years, we expect tax-adjusted returns on municipal bonds to exceed returns of treasury of corporate bonds with similar volatility.3

While there are myriad opportunities in the municipal bond space, there are also important reasons for caution. There are approximately 100,000 issuers of municipal debt in the United States, and perhaps a million different securities. There is a wide dispersion of risk within that universe, from AAA-rated general obligation bonds to unrated land development debt. At the same time, opportunities exist in securities that trade at a discount due to a negative preconception about a state or an issuer. Our experts can help to navigate the space that is at once ripe with opportunity and riddled with complexity.

To learn more about this opportunity, please speak to your J.P. Morgan investment advisor.