Municipal bonds and related exchange traded funds have taken a beating in 2022, but fixed-income investors should not write off this battered bond market segment.
A combination of rising interest rates and elevated inflationary pressures have weighed on both stock and bond markets alike, with fixed-income assets suffering through one of their worst first half of a year since the early 1990s.
While the fixed-income markets retreated, muni bonds have been among the hardest hit and experienced one of their worst sell-offs ever.
“Yet municipal bonds have historically shown that they can reverse course quickly, unlike other pockets of the bond market. Just recently, we’ve seen more stability in the muni market, with investors starting to dip back in to take advantage of bargains,” Catherine Stienstra, head of municipal investments at Columbia Threadneedle Investments, said on MarketWatch.
Specifically, Stienstra highlighted four supporting factors that should help the munis segment rebound ahead, including better adaptability in a rising rate environment, seasonal tailwinds, improving fundamentals, and reduced credit risks.
Stienstra explained that munis have historically outperformed other fixed-income assets during periods that the Federal Reserve raised interest rates since the yield curve flattens during rate hike cycles and creates more attractive income and total return opportunities, especially on later-dated debt.
Munis may also experience a seasonal tailwind ahead after the tax season. The tax-free muni bond segment is typically used among high-income and retail investors, and the bonds will usually experience greater selling pressure ahead of the tax season to pay off taxes or harvest tax losses.
Improving fundamentals or greater demand outpacing tighter supplies could help support the munis market as many muni bonds will mature over the summer period or pay investors coupon payments. The returns can be put back into the muni market as investors reinvest. Local governments also issue less new debt during the summertime as well.
Lastly, Stienstra noted that many states and local governments are flush with cash and are generating budget surpluses, so there is less credit risk in the muni segment, and default expectations are at all-time lows.
“After factoring in the effect of taxes, the taxable-equivalent yield for municipal bonds is particularly attractive,” Stienstra added.
ETF investors who are interested in the munis space can also consider targeted ETF strategies, such as the popular Vanguard Tax-Exempt Bond ETF (VTEB), which costs 0.05%. The fund, which tracks the U.S. muni space via the S&P National AMT-Free Municipal Bond Index, has brought in $4.26 billion in new net assets year-to-date.
For more news, information, and strategy, visit the Fixed Income Channel.