2022 has been a year of adjustments. Reassessing risk and rebalancing asset allocation have been top of mind for investors for many months now. Most asset classes have fallen in value due mainly to inflation risks, elevated interest rates, and higher commodity prices. One market that has corrected more rapidly than usual is Municipal bonds. In Q1, Muni-bonds experienced the weakest quarterly performance, -6.5%, in 40 years.
What are Muni-Bonds?
For those unfamiliar, Municipal bonds are issued by state and local governments to fund general purpose obligations or specific projects, such as highway, affordable housing, and water service.
Income from municipal bonds award investors with tax advantages. Investors receive steady income exempt from federal taxation. Investors within the upper tax brackets have the most to gain from purchasing municipal bonds because of their enhanced tax-equivalent returns.
What’s the opportunity?
In the first quarter of 2022, $20 billion worth of municipals were sold by mutual funds. This selling pressure allowed for yields on some muni-bonds to approach 3.15%; making for a tax equivalent yield of 5.32%. This tax-equivalent yield is greater than treasuries, corporate bonds, and the S&P 500.
It’s worth noting municipals tend to outperform in the late stages of the business cycle, the environment we are currently in. This is because municipals aren’t correlated to an economic slowdown like corporate bonds or equities are.
From a credit quality standpoint, municipals tend to have lower default risk than corporates. Over the past 5 years municipalities have gathered record tax receipts, along with elevated amounts of federal stimulus, that have fortified their balance sheets and credit worthiness.