Investors hoping to generate portfolio income as recession fears grow may seek some safety in municipal bonds. Wells Fargo Investment Institute recently issued its fixed income guidance for 2024, forecasting “higher for longer” rates along the yield curve as the Federal Reserve remains vigilant about reducing inflation. The bank also upgraded government and local general obligation bonds to favorable from neutral, highlighting issues rated double-A by agencies such as Standard & Poor’s and Moody’s. “Given what are generally broad and diverse economies, combined with significant tax increases and opportunities to manage spending, individual states have historically shown considerable resilience when it comes to credit quality, even during of recession and economic uncertainty,” Wells Fargo Investment Institute said in its Nov. 15 report. Municipal bonds offer a combination of characteristics that attract investors: General obligation bonds are backed by the revenues of the municipality that issues them. They generate income that is exempt from federal taxes – as well as state taxes if you live where the bond is issued. Finally, thanks to the Fed’s round of rate hikes, AAA munis yields could be as high as 5% on a tax-equivalent basis. This year, investors poured $4.5 billion into the iShares National Muni Bond ETF ( MUB ) and directed more than $6 billion of new money into the Vanguard Tax-Exempt Bond ETF ( VTEB ), according to FactSet. Best time to get in One reason now is a good time to buy municipal bonds is the outlook for the new year. Although the Federal Reserve gave no indication of potential rate cuts at its last meeting, Fed funds futures prices suggest a chance policymakers will start cutting rates in the spring. “Going into a slowdown, you expect rates to come down,” said Brian Relling, head of global fixed income strategy at Wells Fargo Investment Institute. “Muni bonds tend to have longer maturities and perform well when interest rates fall.” Bond prices move inversely with their yields. When interest rates fall, prices rise – and longer-dated issues have greater price sensitivity to interest rate fluctuations. While investors have piled into cash-like investments, such as Treasuries and money market funds, thanks to higher yields, they will have fewer opportunities to reinvest when interest rates fall; municipal bonds can be a good alternative for investors who wish to lock in a higher yield over a longer period. “Now is the time to go longer and take the worry out of reinvestment risk,” said Jennifer Johnston, director of municipal bond research for Franklin Templeton. She noted that the tax equivalent yield is another consideration when considering municipal bonds. Munis offer lower yields than their taxable counterparts, but to compare them, investors should consider the tax-equivalent yield — that is, the return you’d have to get from a taxable bond to equal the tax-free yield of a muni bond. A taxpayer in the 32% federal income tax bracket would need to find a taxable bond yielding 5.15% to equal a tax-free yield of 3.5%, according to an analysis by New York Life Investments. Investors living in high-tax states can save even more by shopping locally for munis. The highest marginal income tax rate is 13.3% in California and well over 10% in New York and New Jersey. Finding sectors that can handle a slowdown Johnston said she has focused on credit that has benefited from inflation, keeping an eye on state and local governments that can manage the slowdown. In particular, she likes housing bonds. “One of the drivers of inflation is the cost of rent, so that means more reserves for housing authorities, whether it’s workforce housing or essential housing,” she said. States can also issue bonds to invest in affordable housing. Johnston is less optimistic about private higher education, which she says faces demographic challenges and a lot of merger and closing activity. Bonds related to mass transit are also on her radar as costs rise and transit suffers. “New York State has offered good funding to [Metropolitan Transportation Authority]but does that continue?” she asked. “What happens when state-level revenue grows a little slower and there’s not as much revenue?”
