The iShares National Muni Bond ETF (MUB), the largest exchange traded fund tracking municipal bonds, sports a tax equivalent SEC yield of 1.25% as of August 5.
Even in today’s low-yield climate, that’s not enough to get many income-starved investors excited. However, that doesn’t mean investors looking to play some defense in fixed income portfolios and/or those in or nearing retirement should abandon municipal bonds.
In fact, there’s still a strong case for munis – an asset class that’s long been a popular destination for retirement investors seeking low-risk income.
“We don’t believe that low yields should deter investors. Combined with the tax benefits that munis can offer and the improved economic outlook, we suggest muni investors add some lower-rated (BBB/Baa2 to BBB+/Baa1) issuers to their portfolio in moderation. Interest payments for municipal bonds are generally exempt from federal and potentially state income taxes (if purchased from an issuer in your home state),” writes Charles Schwab’s Cooper Howard.
As has been widely noted this year, the case for municipal bonds, despite low yields, is buttressed on two fronts. First, the federal government doled out massive amounts of cash to states to help shore up ailing balance sheets in the wake of the coronavirus pandemic.
Second, the COVID-19 recession was brief and the subsequent recovery is proving intense, helping states collect more tax revenue than was expected in the first and second quarters of 2020. The better states’ finances are, the more credit risk in munis is diminished.
“Credit conditions for municipal bonds have improved considerably from a year ago, which reduces the risk of downgrades and defaults,” adds Howard. “This is due to the substantial fiscal support provided to state and local governments as well as the swift economic recovery. Moreover, economic growth is expected to be strong going forward, with consensus estimates for gross domestic product (GDP) growth currently above 6% in 2021 and above 4% in 2022 based on Bloomberg estimates.”
For now, the climate for munis appears sanguine, something reflected in the low yields across the space. However, investors should stay abreast of coronavirus developments and how those headlines could affect municipal debt.
“A risk to the outlook, however, is the COVID-19 delta variant. If an increase in case count leads to a slowdown in economic growth, it could trickle through to municipalities in the form of lower tax revenues,” concludes Howard. “In addition, if gatherings of large groups were restricted, it would be a headwind for some issuers that rely on large groups, like some transportation issuers.”
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