The Federal Reserve’s efforts to include inflation have taken a toll on the bond markets in latest months. For the reason that starting of the yr, the iShares Core U.S. Mixture Bond ETF (AGG) is down greater than 16%. Whereas that’s higher than the S&P 500 Index, it’s considerably worse than merely holding money in a high-yield checking account.
With the economic system heading right into a recession, the central financial institution’s rate of interest hikes might gradual over the approaching quarters. The slowdown in rate of interest hikes might assist stabilize rates of interest, making the bond market extra engaging, significantly as a secure haven. And, because of its distinctive traits, the municipal bond market seems particularly engaging.
Let’s look at why the muni bond market seems so inviting and the place traders can hunt down the very best alternatives.
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Stabilizing Costs With Engaging Yields
The U.S. economic system is exhibiting indicators of a cooldown, with the Convention Board predicting a 96% chance of a U.S. recession over the subsequent 12 months. Paradoxically, an financial slowdown might enhance bonds by stabilizing rates of interest whereas rising demand. In consequence, bond costs might begin to recuperate after a historic bear market.
Previous spikes within the spreads between 10-year AAA muni yields and after-tax 10-year Treasury yields had been adopted by fast retrenchments (greater costs). Supply: Goldman Sachs
On the similar time, U.S. Treasury yields are greater than they’ve been in years, with the 10-year peaking at round 4%. The municipal-to-Treasury yield ratio can be a lot greater than historic averages at about 86%, indicating a pretty relative yield. Tax-exempt revenue compensation for traders prepared to purchase now’s at historic highs.
Properly-Positioned for an Financial Downturn
State and native governments have robust steadiness sheets because of federal pandemic support packages and a powerful financial efficiency in 2021 and early 2022. With sizable reserves, they’re in a a lot stronger place to climate an financial downturn. For example, California had a $31 billion surplus and Florida had an $11.2 billion surplus final yr.
In the meantime, state and native tax revenues proceed to rise, because of optimistic financial progress. Greater than 30 states reported higher-than-expected income in 2021, based on the Nationwide Affiliation of State Price range Officers, with total state income (together with federal funds) rising by greater than 12% final yr.
Demand Outstrips Provide
The provision of municipal bonds continues to say no, because of fewer refunding points. With sturdy steadiness sheets and a sharply greater value of capital, state and native governments have been gradual to problem new bonds at greater rates of interest. In consequence, the muni bond provide will doubtless stay tight till rates of interest stabilize subsequent yr.
Whereas the general muni market has seen web outflows this yr, municipal ETF flows got here in at a optimistic $13.7 billion by means of September. Excessive after-tax yields might draw in additional traders early subsequent yr when charges stabilize. And the potential for a U.S. recession might additionally sharply enhance demand as traders search safe-haven investments for his or her capital.
Muni Bond Alternatives
The most important muni bond ETFs by belongings below administration embody:
Knowledge as of November 1, 2022
The Backside Line
The bond market skilled an unprecedented drop over the previous few months, however stabilizing rates of interest might result in a restoration. Particularly, municipal bonds might see a powerful restoration as traders search a high-yield safe-haven funding throughout the upcoming recession. In consequence, traders could wish to try muni mutual funds and ETFs for his or her portfolios.
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