Municipal bonds are having a decent year. As of July 10, the widely observed ICE AMT-Free US National Municipal Index is higher by 2.08% -- a decent showing for this asset class over barely more than six months.
That has some market observers optimistic about the prospects for munis in the second half of 2023, particularly because fundamentals for these bonds, even high-yield fare, remain sound. Additionally, many clients’ needs for income and tax benefits haven’t waned. If anything, those demands are increasing.
Last year, munis, like other bonds, were pinched by the Federal Reserve’s scorched earth campaign of interest rate hikes. But on a relative basis, municipal debt proved to be a one of the better corners of the bond market and some of that positivity matriculated into 2023, likely explaining why some market observers are enthusiastic about the asset class in the second half.
That could be welcomed news for advisors looking to source income for clients without taking excessive credit risk.
Good Reasons to Mull Munis Today
Advisors know that forecasting the Federal Reserve’s plans for interest rates can be a fool’s errand. For now, Fed funds futures point to no further rate hikes over the remainder of 2023. Conversely, some economists argue that with the jobs market hot and inflation still high, the central bank may be forced into raising rates again this year.
Fortunately, clients will be compensated for that risk – one that may not materialize –with municipal bonds. That is to say yields on these bonds are unusually high today.
“Just two years ago, the yield for a broad index of muni bonds was 1%, which was near the lowest level in the history of the index,” according to Charles Schwab research. “In dollars and cents, it would take a portfolio of $1 million to generate $10,000 of interest income. An investor would need a very sizeable investment for not much income. That's no longer the case today. Since the trough in July 2021, yields have increased to above 3.5%. To generate the same $10,000 of interest income, an investor would now need a portfolio of roughly $280,000.”
While other corners of the bond market offer yields well in excess of 3.5%, it’s worth noting that municipal bond fundamentals are strong. Translation: Issuers, those being cities and states, are proving adept at generating and collecting tax revenue. That’s true even in some fiscally challenged states – notable because some of those are among the largest issuers of municipal debt.
Where to Focus on the Curve
Obviously, duration is critical in making fixed income decisions. Today, longer-dated bonds may not be worth the risk because the Fed could surprise with unexpected rate hikes. Likewise, the compensation offered by short duration bonds may not be adequate for some clients.
That leaves the intermediate part of the yield curve, which Schwab extols as a preference for entering muni land. It’s something for advisors to consider in the back half of the year.
“We often hear from clients, ‘why should I invest in intermediate-term bonds if I can get the same or an even higher yield with shorter-term bonds?,’” concludes Schwab. “The answer is simple: ‘reinvestment risk.’ By purchasing some longer-term bonds, investors are locking those yields in rather than staying in short-term bonds and being more subject the changes in interest rates.”
Related: Advisor Interest in Income Is Rising