Municipal bonds today offer U.S. taxpayers a rare, compelling opportunity

The municipal bond market’s current yields should be music to U.S. taxpaying investors’ ears. But the chance to buy at these levels will probably be fleeting.

Our research suggests that at today’s entry point, implied yields for municipal bonds are over 7%, after factoring in the U.S. taxpayer advantage. Historically, this has only occurred about once every five years.

We’ll show you the opportunity—and consider the potential impact on the muni bond market of California’s tragic wildfires.

Why long-dated munis are exciting right now

The opportunity in long-dated municipal bonds is noteworthy right now. The benchmark Bloomberg Municipal Long Bond (22+) Index is currently yielding about 6.91% on a yield-to-worst,¹ tax-equivalent yield (TEY) basis.²

As the graph illustrates, this benchmark index of municipal bonds with long maturities has breached the 7% threshold 11 times since 2007, making this a relatively rare moment.

At all those times in the past, the 12-month forward return (TEY) exceeded 5.50%. Even more impressively, in all those cases historically, 24-month forward returns of the benchmark index went on to reach 12% (TEY).

As we witness similar conditions arise now, the market looks attractive for U.S. taxpaying investors over the next two years—if they lock in the yield now.

The line chart’s brief peaks above 7% also show why time is of the essence: Historically, the index’s cheapening cycles (those 7%-plus periods) have lasted only 54 days on average.

For U.S. taxpaying investors able to lock in muni bond yields now, this advantageous moment extends across maturities to varying degrees (as the next chart shows). Our research here is a historical study of investment outcomes for one- and two-year periods since 1980 for investors who bought into the market at those times when yields breached 7%.

Municipals shine in inflationary times

Since 1980, the Bloomberg Municipal Long Bond 22+ Index has returned 6.57% on average, per year—besting the Bloomberg U.S. Treasury Index, which returned 6.30% over the same period (factoring in the asset class’s U.S. tax advantage).

Interestingly, during the high inflation period between 1980 and 1990, both the shorter-dated Municipal Bond Index and the Municipal 22+ Long Index even outperformed equities—the S&P 500, Dow Jones Industrial Average and the Russell 2000, when calculated using the highest bracket tax rate (40.8%), and again factoring in the break for U.S. taxpayers. 

Municipal bonds aren’t expected to outperform equities over the long term. However, all the income these securities generate may be exempt from federal taxation for U.S. taxpayers and, depending on your residence, may be exempt from state and local taxation, as well. This tax-free income advantage makes them a compelling opportunity today.

Reflecting on the impacts of the Los Angeles wildfires

We are profoundly concerned about the fires that have affected the Los Angeles region, and sincerely hope for the safety and well-being of our clients and colleagues in the area. Despite the unknowns at this juncture, we can still provide some perspective, based on recent historical precedent when it comes to climate change risk, to help us evaluate the potential impact on municipal bond investors.

Climate-fueled disasters can introduce portfolio risk, and we monitor this closely for bonds that could be adversely exposed. As we wrote in an earlier look at the municipal market, it enjoys a history of very low default rates; state and local government budgets are generally balanced, and their “rainy day funds” have been robust.

Indeed, we do not forecast any payment defaults to occur for any city, county or school district adversely impacted by the Los Angeles fires. However, public power utilities and investor-owned utilities (IOUs) with municipal debt outstanding are more open-ended questions. We do not yet have all the definitive answers.

Public and investor-owned utilities under pressure

A number of Southern California utilities have bond issues outstanding, and some are experiencing ratings pressure.

On February 3, Standard & Poor’s Ratings Services downgraded the outlook of Edison International’s Southern California Edison (SCE) unit to “negative” from “stable” due to the company’s potential exposure to the Los Angeles wildfires. The issuer’s current credit rating is BBB.

The negative outlook notice for SCE’s bonds “reflects the potential that the California Wildfire Fund could be materially depleted,” given the significant number (over 10,000) and value of the structures “damaged or destroyed by the Eaton Fire, and the possibility that SCE’s equipment may be linked to the fire,” an S&P Ratings statement said.

The negative outlook also reflects “the potential for a more challenging operating environment for Edison and SCE due to wildfire risk, which could weaken credit quality,” the S&P Ratings statement said.

The University of California estimates the Eaton fire resulted in USD95 billion to USD164 billion in property damage.

Additionally, S&P cautioned in late January that the fires could lead to negative ratings actions for public power utilities’ bonds broadly. The S&P report named the Los Angeles Department of Water and Power, Burbank Water and Power, Glendale Water and Power, and Pasadena Water and Power. Collectively, these issuers have USD19.5 billion of debt outstanding.

Are defaults likely? We cannot yet know. Should a utility be found liable for igniting a fire, that would open the possibility of a bankruptcy filing, considering the significant costs associated with these fires.

This was the case for Pacific Gas and Electric (PG&E) and Hawaiian Electric—both found liable for fires. PG&E, an IOU, filed for Chapter 11 bankruptcy protection in 2019 to resolve its wildfire liabilities, and reached a USD13.5 billion settlement as part of its bankruptcy reorganization. Hawaiian Electric has so far avoided bankruptcy; it recently reached a USD4 billion settlement with individual and class action plaintiffs.

We highlight that unlike corporate credit market issuers, which have a profit motive and an interest in protecting shareholders’ and bondholders’ values, public finance and municipal issuers are under a different mandate: to provide the highest level and quality of government service at the lowest possible tax rate.

As a consequence, rather than strategically declaring bankruptcy, municipal issuers are far more likely to work to access federal funds, to lean on other entities covering the same geography for needed services, and to receive support from neighboring municipalities when they experience a crisis. The decision to default on debt service is rarely (if ever) made strategically, but only out of necessity.