Rising inflation and the expectation of higher interest rates might seem like it could tamp down demand for municipal bonds, but there are other factors working in their favor.

2021 saw increased demand for munis in a year of recovery after the onset of the ongoing pandemic in 2020.

“In retrospect, the 2021 municipal bond market continued to benefit from the bounce back of its devastating reaction to the onset of COVID-19 in 2020,” a Business Journal article notes. “Credit spreads continued to narrow while credit quality continued to improve, and in the meantime, the constant threat of higher taxes resulted in record inflows into the municipal market. These factors led to a positive year for municipal bonds and should continue to be a strong driver of performance in 2022.”

With tax increases forthcoming, the demand for munis should continue in 2022. Additionally, the ongoing recovery means that credit quality will continue to rise, giving risk-averse investors more peace of mind.

“2022 brings the expectations of continued strong demand for municipal bonds, as the main drivers of the municipal market are all positive,” the article says. “First and foremost are taxes. Investors are still worried about higher taxes and will do what they can to avoid them, which will keep demand strong.”

“Credit quality of issuers continues to strengthen as state and local balance sheet — which were robust going into the pandemic — came out even stronger due to massive federal stimulus,” the article adds further. “New issue supply forecasts average approximately $450 billion, which is lower than the $470 billion in 2021, according to Bloomberg. This lower issuance will lead to another supply shortage if cash inflows continue at their torrid pace of 2021. Finally, municipal valuations relative to taxable counterparts are off their extreme high and have settled into a more reasonable level, allowing room for the market to outperform taxable bonds once again.”

Getting Tax-Free Muni Exposure

One place to get tax-free municipal bond exposure is via an ETF wrapper with funds from Vanguard such as the Vanguard Tax-Exempt Bond ETF (VTEB). With a 0.06% expense ratio, the fund offers low-cost exposure to municipal debt.

VTEB tracks the Standard & Poor’s National AMT-Free Municipal Bond Index, which measures the performance of the investment-grade segment of the U.S. municipal bond market. This index includes municipal bonds from issuers that are primarily state or local governments or agencies whose interests are exempt from U.S. federal income taxes and the federal alternative minimum tax (AMT).

For more news, information, and strategy, visit the Fixed Income Channel.