The Federal Reserve’s efforts to comprise 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 financial 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 enticing, significantly as a secure haven. And, because of its distinctive traits, the municipal bond market seems particularly enticing.
Let’s study why the muni bond market seems so inviting and the place buyers can hunt down the very best alternatives.
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Stabilizing Costs With Enticing Yields
The U.S. financial system is exhibiting indicators of a cooldown, with the Convention Board predicting a 96% probability of a U.S. recession over the subsequent 12 months. Satirically, an financial slowdown might enhance bonds by stabilizing rates of interest whereas rising demand. Because of this, 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 have been adopted by fast retrenchments (larger costs). Supply: Goldman Sachs
On the identical time, U.S. Treasury yields are larger than they’ve been in years, with the 10-year peaking at round 4%. The municipal-to-Treasury yield ratio can also be a lot larger than historic averages at about 86%, indicating a sexy relative yield. Tax-exempt revenue compensation for buyers keen to purchase now’s at historic highs.
Nicely-Positioned for an Financial Downturn
State and native governments have sturdy 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 constructive financial progress. Greater than 30 states reported higher-than-expected income in 2021, in line with the Nationwide Affiliation of State Finances Officers, with general 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 strong steadiness sheets and a sharply larger value of capital, state and native governments have been gradual to concern new bonds at larger rates of interest. Because of this, the muni bond provide will seemingly stay tight till rates of interest stabilize subsequent yr.
Whereas the general muni market has seen internet outflows this yr, municipal ETF flows got here in at a constructive $13.7 billion by way of September. Excessive after-tax yields might draw in additional buyers early subsequent yr when charges stabilize. And the potential for a U.S. recession might additionally sharply improve demand as buyers search safe-haven investments for his or her capital.
Muni Bond Alternatives
The biggest muni bond ETFs by belongings below administration embrace:
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. Specifically, municipal bonds might see a powerful restoration as buyers search a high-yield safe-haven funding through the upcoming recession. Because of this, buyers could wish to try muni mutual funds and ETFs for his or her portfolios.
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