Strong municipal bond market fundamentals can prevent a repeat of 2008

Investors have found a few safe havens amid a tough economic backdrop in 2022. The influx of stimulus programs from the COVID-19 era – which has fueled economic growth over the past two years – is now being suppressed. withdraw.

Against that backdrop, most asset classes’ returns have eroded. And yet, many state and local governments have used growing tax revenues and fiscal stimulus measures over the past few years to bolster fiscal positions. Result? A municipal bond market with strong fundamentals appears to be preparing for the upcoming market of uncertainty.

Yin versus yang of the muni chợ market

Without a doubt, 2021 is a special year for muni investors. Low interest rates, tight credit spreads, and rising bond prices. However, that result was far from what was expected at the start of the cycle. Back in early 2021, many cities expected large revenue declines. To prepare, they knocked down the hatches and cut costs.

Reduced revenue never materialized.

Instead, federal government-funded bailouts — in the form of the Coronavirus Aid, Relief, and Economic Security Act (CARES), and the American Rescue Plan Act (ARPA) — helped fill local coffers. At the same time, house prices and wages continue to rise, increasing revenue from property taxes and wages.

Then came the year 2022, followed by a round of financial turmoil that brought financial markets back from overvalued levels. Munis falters, along with most asset classes. However, the market moves in cycles. This year’s shift, when viewed through a wide-angle lens, reflects that cyclical nature. COVID-era monetary policy and fiscal stimulus programs are reversing. After that, interest rates are rising by historical standards. In short, the economic momentum of 2022 is bringing muni bonds into a period of normalization.

However, municipalities are still financially viable

Many state and local governments have deployed COVID-era stimulus measures to fortify themselves against future recessions by building a rainy day fund and funding pension obligations. Going forward, tax revenue is likely to remain stable, as assessed valuations will not decline to the same extent or extent as the slowing housing market.

The combination of previous and future revenue streams is not only good for cities but also positive for their investors. As fall kicks in, the city’s average productivity is at a 10-year high. It’s a high-quality asset class (over 85% of the market is rated A or higher, according to our analysis of market data) with a strong underlying risk profile, especially compared to corporate bonds.

Current valuations, especially among long-term issues, are close to Treasury valuations, which are typically subject to federal income tax. In contrast, Muni bond interest is not taxed at the federal level. And states do not tax interest on the bonds they issue to their residents. That means today’s munis are paying investors a higher amount of tax-free income than comparable taxable income.

Note that while municipal bond fund income is exempt from federal taxes, you may owe tax on any capital gains received through the fund’s trading or through the repurchase of its stock. yourself. For some investors, a portion of the fund’s earnings may be subject to state and local taxes, as well as the federal Alternative Minimum Tax.

Despite rumors of a recession, the future of the muni market is bright

With signs that we may be headed for a recession, the munis – especially the high-quality space ones – seem poised to weather the storm. The recession will inevitably lead to some revenue decline, but many municipalities will face those obstacles from a solid base. The combination of low debt and sufficient cash can act as a buffer against a downturn.

In fact, munis is in much better shape than it was in 2008 before the global financial crisis. At the time, many US states were facing budget shortfalls, some of them quite severe.

This is far from the case with many local governments today, which is great for investors. For example, at Vanguard, we are actively upgrading the quality of our muni portfolio while repositioning the higher interest rate regime we appear to have entered.

Despite the widespread financial turmoil, muni observers are seeing a market as compelling as it has been for decades. Rising rates and high-quality credit are always available. At the same time, local bonds are relatively cheap on both fundamentals and historical grounds. This could be a great time to get into this fascinating property class — but only if you intend to stay for the long term.

Paul Malloy is the city’s head of credit and investment research at Vanguard.

Note: All investment activities carry risks. The fund’s prospectus includes investment objectives, risks, fees, costs and other information; Read and consider carefully before investing. Vanguard Marketing Corporation, Distributor.

Opinions expressed in commentary are solely those of their authors and do not necessarily reflect the opinions and beliefs of Luck.

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