Municipals
CaptiveAudience,CreditStrengthMayBuoyMunisAmidRateVol
5 mins
One common perception in 2022 is that tax-exempt municipal bonds face a tough stretch given the potential for further interest-rate volatility. Yet, contrary to those logical expectations, consistent demand from tax-sensitive investors and strong credit fundamentals have historically buoyed the asset class during periods of heightened rate turbulence.
Despite their reputation as interest-rate sensitive investments, one only needs to look back to 2021 to observe the resiliency of municipal bonds as the sector outperformed nearly every other fixed income asset class despite rising Treasury yields. As the 10-year Treasury yield rose by nearly 60 bps last year, 10-year municipal bond yields rose by only 31 bps, about half as much.
Perhaps more compelling, municipal bonds have consistently shown a relatively muted response to rising taxable rates going back for more than 15 years. Figure 1 shows that for every 50 bp move (or more) in Treasury rates, the commensurate municipal bond move was slightly more than 60%, on average, since 2004.
Figure 1
Municipals Response to Rising Rates Over Time
PGIM Fixed Income.**Values reflect move in bps.
Less Sensitive to Rising Taxable Rates
Consistent demand for tax-exempt bonds is largely responsible for keeping municipal bond rate movements subdued, which can be illustrated through a simple example.
- To keep the math easy, we assume a 10-year municipal yield of 1% and a 10-year U.S. Treasury yield of 1.5%.
- Dividing the municipal bond rate by the Treasury rate generates a ratio of 67%, or an implied marginal tax rate of 33%.
- Put differently, buying the Treasury bond at 1.5% with a 33% marginal tax rate is equivalent to buying a tax-exempt bond at 1%.
- If rates went up by 1 percentage point on both municipal bonds and Treasury bonds, the implied marginal tax rate would fall to 20% (i.e., a 2% municipal yield divided by a 2.5% Treasury yield results in an 80% ratio, or a 20% implied tax rate).
- In the above example, municipal bond rates should only move by about 0.67 of a percentage point for the commensurate 1.00 percentage point move in order to maintain the hypothetical 33% marginal tax rate.
In a perfect world, demand for the tax benefit should remain relatively consistent with marginal tax rates. While the implied marginal tax rate changes as the ratio between tax-exempt bonds and taxable rates move, the reality is that there is a limit to the implied tax rate that the market is willing to bear.
Yet, strategies to help offset both current and potential tax rates provide a consistent source of demand for tax-exempt municipals—no matter how Treasury rates are behaving. For example, when state- and local-tax deductions were capped in 2017, municipal bonds in states with the highest marginal tax rates became more attractive for tax-sheltering purposes. Additionally, a wave of inflows came into the municipal bond market in 2021 due, in part, to expectations of higher tax rates to fund the Build Back Better plan.
Strengthening Fundamentals
Credit fundamentals may be another reason for investors to look at the municipal sector in 2022 as municipal bonds issued from government entities are among the strongest credits. Indeed, municipal bonds have lower historical default rates than similarly-rated corporate bonds with the latter likely becoming more susceptible to even risk from debt-financed stock buybacks, M&A transactions, or capital expenditures.
More recently, many municipal entities exited the COVID crisis stronger than before helped by nearly two years of stimulus support, with an estimated $1.2 trillion flowing into municipal entities from government programs. At the same time, tax collections have risen sharply amid widespread vaccinations, the easing of public restrictions, and federal aid. (Figure 2)
Figure 2
Municipal Tax Collections on the Rise
J.P. Morgan, individual state monthly tax reports. Adjusted for reporting lags. As of November 23, 2021.
This backdrop has resulted in healthy cushions for many municipal issuers, even those with previously weaker balance sheets. For example, Illinois is making a rainy-day fund deposit for the first time in recent history, New York announced five consecutive years of balanced budgets, and California will pull down an eye-popping $45.7 billion in surplus funds over the coming years. The stimulus funds have also reached beyond traditional states and local governments, extending to schools, hospitals, and airports.
Looking Forward
While we see conditions that could prolong the environment of historically low interest rates, investors logically remain concerned about the effects from further volatility in long-term Treasury yields. As “rate-sensitive” investments, municipal bonds have suffered from some of this volatility as the Fed tries to tame inflation with an equal diet of rate hikes and balance sheet management. However, history has shown that over the long-term, municipal bonds hold up relatively well during periods of rising rates and—given the role they play in the portfolios of tax-sensitive investors and the strong fundamental backdrop—we expect to see this relationship to carry forward into 2022.
