iShares: Four Reasons to Like Muni Bonds

ETF Trends

I’ve been in the business for many years, since the 1980s in fact, and it’s been fascinating to see the evolution of the municipal asset class from a once specialized (and some have said “sleepy”) investment alternative to a widely recognized fixed income vehicle — one that is in demand and highly prized for potential income generation.

Why are investors seeking more and more munis? I’d say there are four main factors, which I will cover here in my 30,000-foot view of Muniland. In future posts, I’ll delve more deeply into these and other topics, and I also look forward to hearing from you with any questions you’d like me to answer when it comes to muni bonds.

1. Tax Benefit, Anyone? Munis are unique investment vehicles in that they are generally exempt from federal and, in some cases, state taxes. No other financial assets can make the same claim. This also means munis are among the only assets to increase in value when tax rates rise, as they have since the fiscal cliff deal was negotiated at the start of the year. Now, under normal circumstances, munis will generally offer lower yields than Treasuries before taxes, and then make up for them on an after-tax basis. However, in today’s low-rate environment, we’re seeing munis outyield Treasuries before taxes … and that just sweetens the deal.

2. Munis Care for the Community. OK, I’ll admit that may sound a bit melodramatic. But here’s the thing: Municipal bonds are issued by state and local governments to fund the construction of schools, roads, bridges, hospitals, housing projects … the list goes on and on. So, by investing in municipal bonds, you’re able to support projects intended to build and bolster the communities in which you live and work, and there’s a certain satisfaction in that. You can support the construction of a much-needed medical facility or local firehouse while earning income on the bonds issued to fund it. I’d call that a win-win.

3. High Quality … Talk of municipal defaults makes for provocative headlines, but the truth is that defaults are quite rare, even in the wake of the Great Recession. I’ll discuss the recent developments in troubled Detroit in a future post, and we offer overarching views in State of the States and Local Governments, but ultimately, the data is telling. Moody’s conducts comprehensive analyses of municipal and corporate bond defaults and has consistently found municipal bond defaults to be infrequent and isolated events. The credit rating agency counted only 71 muni bond defaults over the period 1970-2011 compared to more than 1,800 corporate bond defaults over the same timeframe.* Moody’s data further shows that relative to corporate bonds, municipals have proved much safer and provided higher recovery values. This is partly because state and local governments have tacit social, economic and political motivations to continue providing facilities and services to their stakeholders.

4. … Generally Lower Volatility. It’s not that munis don’t experience the highs and lows of the financial markets. In fact, we saw this in dramatic fashion in late May and June . But history shows us this is the exception rather than the rule. Typically, munis’ response to market-moving events is much more muted than that other fixed income assets. This intrinsic cushion has made for a relatively smoother ride for muni investors over the long term.

The municipal bond market has evolved considerably over the years. It weathered major tax reform changes in 1986, and the loss of big investors in the aftermath. Between the 1990s and 2000s, it saw the rise and fall of municipal bond insurers. Five years after the 2008 credit crisis, it has completed its transition from an interest-rate-based market to one driven more by credit events. Although I doubt I’ve seen it all, I have lived and invested through enough to know that I still like what I see today.

Peter Hayes is Head of the Municipal Bonds Group at BlackRock.

* Moody’s Investors Service Special Comment, “US Municipal Bond Defaults and Recoveries, 1970-2011,” March 7, 2012, and Moody’s “Annual Default Study: Corporate Default and Recovery Rates, 1920-2012.”

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