No one can predict for sure what lies ahead for the markets or economy. But amid a stream of weak economic data, investors are on edge. If ever an anthem of resilience was needed, it’s now.
The challenging mix of macroeconomic factors is prompting many investors to implement strategies aimed at helping them maintain a defensive posture. These investors may want to take a closer look at municipal bonds. Over time, and particularly during a recession, muni bonds have earned a reputation as a relatively secure and reliable investment alternative.
Here are six reasons munis can potentially enhance stability in investor portfolios.
Municipal bonds finance services that are essential to communities, such as utilities, schools, hospitals, and infrastructure projects. Given the indispensable nature of these services, their tax revenues can remain stable well into an economic slowdown. After all, it’s more likely that people will prioritize paying utility bills over going out to dinner or buying a car. During the pandemic, projections that state and local tax revenues would take a hit prompted the federal government to issue billions of dollars in aid to municipalities, which bolstered states’ revenues. Surprisingly, tax revenues remained stronger than projected through the pandemic and, by the end of fiscal year 2022, states had amassed a record $134.5 billion in rainy day funds. Notably, not all states ended the fiscal year deep in the black, or rather blue, as the chart below shows. The amount of rainy day savings varied significantly, from 349.6 days' worth of expenses in Wyoming to zero in New Jersey.
Number of Days Each State Could Operate on Savings Alone (FY 2022)
Although credit downgrades within the muni bond market certainly occur, historically, downgrades for munis are far less frequent than they are for corporate bonds. According to credit rating agency Moody’s Investors Service, in any given year, approximately 1% of muni bonds with credit ratings of AAA, AA, and A were downgraded between 1970 to 2021. That compares to the global corporate market, where downgrades reached 5% or higher.
But how well can muni bond credit ratings hold up in a recession? Forty years of data shows they experienced a significantly smaller proportion of negative ratings actions during recessions than corporate bonds.
While municipalities may need to tighten their belts, cut spending, or even lay off workers during an economic slowdown, that is generally as bad as it gets. Defaults on payments to bondholders rarely happen. When they do, they tend to occur with project-specific bonds at the lower end of the credit quality spectrum, a segment of the market Riverbend avoids. All this is to say that muni bonds are typically solid performers—even during a recession. The cumulative default rates for investment-grade muni bonds averaged just 0.09% in the decade ending December 2021, Moody’s data shows. In contrast, the global corporate market experienced a default rate of 2.17%—well over 20 times that of munis.
Muni bonds also offer diversification benefits to investors. Because they’re issued by state and local governments, they are associated with specific geographic regions. Additionally, municipal bonds are not highly correlated with corporate profits or market volatility. As such, they can be a reliable source of income during a downturn when other assets may be more volatile.
Because munis are frequently long-term investments, cyclical economic downturns may be less of a concern for investors in these bonds. Munis issued with long-term maturities can provide a steady source of income over time compared to equities or other assets that might be vulnerable to short-term market volatility. Additionally, because muni bond interest rates are usually fixed, investors are guaranteed a constant rate of return throughout the duration of the bond.
Let’s not forget the tax benefit of investing in muni bonds, which is perhaps their biggest advantage. Depending on where a muni bond was issued and where the investor resides, the interest income from munis is generally exempt from federal income tax and, in some circumstances cases from state and local taxes as well. For high-income earners who are trying to reduce their tax liability, the tax-exempt status of munis is a significant draw—in any economic environment.
Market cycles are inevitable. There will be ups. There will be downs. At Riverbend, we position our clients’ portfolios in anticipation of full market cycles, consistently investing in higher-quality muni bonds with defensive characteristics We’re also opportunistic. The current interest rate backdrop is greatly improved from that of 2020–21, presenting opportunities to accumulate bonds offering better yields. By incorporating callable structures into most of our clients’ portfolios, we believe we can generate incremental yield.
Our investment philosophy is simple: Make the best of the current market for our clients while preparing for what may lie ahead.