Municipal Bonds: Why Now is the Time

What if we told you that currently, top U.S. taxpayers can out-yield cash (after tax considerations) by investing in municipal bonds? 

We think municipal bonds’ currently high yields offers a chance to reach toward your financial goals with less risk—you may want to consider deploying some cash into this fixed income sector, or perhaps consider reallocating some of your fixed income. Even more, depending on your goals, you may also want to consider rotating some of your holdings out of equities or other higher risk investments.

The case for municipal bonds is also strong when you adjust for the risk. The municipal market enjoys a history of very low default rates. (State and local government budgets are also generally balanced and “rainy day funds” are currently robust.) Within the fixed income arena, municipals now offer appealing relative value to corresponding lower-risk bonds.

Here’s more on why.

The compelling yields offered by municipal bonds

In recent months, strong U.S. economic performance and expectations that a second Trump term will stimulate both growth and inflation have pushed interest rates to levels rarely seen throughout the last 15 years. On a taxable-equivalent yield basis,¹ municipal index yields² now exceed those of cash and also rival fixed income investments of higher risk. In high tax states like New York and California, A-rated municipal bonds offer taxable-equivalent yields (TEYs) of nearly 7.0%. Additionally, the mean ten-year cumulative default rate for all investment grade municipals is only 0.10%. (Recent credit trends have exhibited no material differences.)³

Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Additionally, this year’s election results have incited discussions that a removal of the municipal bond tax exemption could be used to help fund the extension of the Tax Cuts and Jobs Act. We, alongside many market pundits, believe that fully repealing the exclusion is unlikely, as all previous attempts were defeated. Further, changing the exemption wouldn’t raise a sufficient amount of tax revenue. The Tax Policy Center estimated that interest on public purpose state and local government bonds cost just $27bn in forgone tax revenues in 2022.⁴

Looking further into the future, J.P. Morgan Asset Management’s latest Long-Term Capital Market Assumptions project that the 10-year U.S. Treasury (UST) yield will fall to 3.9% over the next 10 to 15 years, down from about 4.4% today. We expect that municipal yields will follow. With this outlook, we believe now is a time for tactical and strategic asset allocators to consider municipal bonds.

Wealth preservation: Municipal bonds’ resilience and low default risks

Federal debt has ballooned to more than 100% of GDP, with expectations that a second Trump term will push the federal debt to GDP ratio to 132% over the next 10 years. Meanwhile, state and local debt-to-income ratios have remained near their same thresholds for a half century. The majority of municipalities must propose and/or sign a balanced budget and, in 2015, 38 states required their legislatures to pass balanced budgets.⁵

Cumulatively, the $4 trillion municipal bond market has an average credit rating of AA⁶ , the same as the U.S. federal government.

Also comforting for investors: the median state rainy day fund balance has surged to 13% of general fund spending, thanks to COVID-era federal policies that saw the federal government borrow and distribute funds to citizens and municipalities to fuel economic growth.

These rainy day funds—which are typically dedicated cash reserves set aside for unexpected expenses or an unforeseen revenue changes—have grown steadily since 2011, when they equaled just 1.8% of general fund spending (in the wake of the global financial crisis). 

The largest issuers of tax-exempt bonds—California, New York, Texas, Illinois, Florida, Pennsylvania, and New Jersey—now have much larger rainy day fund balances than they did ten years ago, as a percentage of general fund spending.⁷

Healthy balance sheets suggest states and municipalities will be even more resilient to any unfortunate economic shocks, if they lie ahead.

Munis offer more relative value to bonds with similar risks

In the search for yield, municipal bonds shine relative to similar, lower-risk fixed income investments, such as US Treasuries and investment grade bonds. Currently, tax-free municipal bonds yield 70% as much as (federally taxable) UST bonds. That’s lower than the historical average, but this comparative strength has been supported, in part, by the healthy demand dynamics bolstered by the market’s many tax-advantages. 

Municipal yields also compare favorably with investment grade bonds. Munis offer ~55% of the average investment grade bond’s yield. Over the last five years, this metric averaged only 50%.⁸ Importantly, TEYs for certain high-bracket investors can be more than double those offered by comparable taxable securities, particularly when considering the 3.8% Medicare Surtax exemption and the current limitation of the state and local tax (SALT) deduction, if/where applicable.

Overall, we believe that compelling relative value dynamics, coupled with the present outlook on taxation, suggest that municipals offer an attractive opportunity for those investors looking to lock-in tax-exempt yields within an asset class of exceptional creditworthiness. 

A compelling opportunity

The bottom line? We believe the current environment is a favorable one for investors to add some exposure to municipal bonds. As attractive yields meet low default risk, investors may have a compelling opportunity to achieve their financial goals with less risk. Please reach out to a J.P. Morgan team to discuss planning objectives, as well as personally-tailored credit and yield-curve positioning strategies. 

¹The taxable equivalent yield (TEY) measures what an investor would have to earn (yield) on a taxable investment to match the yield of the tax-free municipal bond. Taxable equivalent yield assumes a federal tax rate of 37% and Medicare surcharge on investment income of 3.8%.

²Bloomberg 10-year Municipal Bond Index.

³Moody’s Investors Service annual municipal bond market snapshot, US municipal bond defaults and recoveries, 1970-2022.

⁴https://taxpolicycenter.org/briefing-book/what-are-municipal-bonds-and-how-are-they-used

⁵ “The State of State (and Local) Tax Policy,” Tax Policy Center Briefing Book, Urban-Brookings Tax Policy Center, 2022.

⁶Average of credit ratings from S&P, Moody’s and Fitch.

⁷National Association of State Budget Officers (NASBO), Fall Fiscal Survey of States (1989 - 2023) and Spring Fiscal Survey of States (2024). Survey data were self-reported by executive state budget officers. The source edition for each fiscal year of data is noted at the bottom of the RDF Balances table.

⁸ Bloomberg Finance L.P., J.P. Morgan. Data as of October 31, 2024.