Yes. Munis still have value on an after-tax basis over the long term, and their near-term outlook has improved following the rise in yields and spreads during this year’s sell-off. Still, the economic and policy backdrop remains challenging. Thus, we believe it is reasonable for most taxable investors to hold a reduced portion of their fixed income allocation in munis relative to their policy, given munis have come under pressure during previous periods of market stress.
Most taxable investors favor munis over comparable Treasuries and corporates because of their relative safety for a spread product and tax benefits. Historically, munis have been a low-default asset class, and they have usually behaved more like Treasuries than other spread products, while also outperforming Treasuries over the long term on an after-tax basis. A buy-and-hold taxable investor would have earned an additional 200 basis points (bps) per annum between 1980 and 2020 by holding munis instead of Treasuries after adjusting for taxes.*
Despite this rather large opportunity cost, recent experience has led many taxable investors to question the role munis play in their portfolios. Some have trimmed their muni allocation because the high correlation between munis and Treasuries over the long term temporarily breaks down during periods of market stress. This makes munis a poor crisis hedge, especially relative to Treasuries, as was the case during the Global Financial Crisis (GFC) and the height of the market downturn in early 2020. During the latter, munis declined by as much as 10.9% in less than a month and trailed Treasuries by around 14 percentage points.
Fixed income broadly has struggled this year as high inflation and aggressive monetary tightening have caused a sharp increase in both interest rates and credit spreads. Munis were vulnerable heading into 2022, given their low yields and rich spreads. Ten-year munis were barely yielding 1% at the end of last year and the ratio between ten-year muni and Treasury yields was only 0.67 times, which is just slightly above its record low of 0.56 times. As a result, the Bloomberg Municipal Bond Index suffered its worst start to the year on record, returning -9% in the first half of 2022, as investors pulled over $80 billion from muni mutual funds during this period, according to Investment Company Institute data. However, unlike more recent periods of market stress, munis have held up relatively well versus Treasuries, while the near-term outlook for munis has improved.
Munis are more attractively valued following this year’s sell-off. Ten-year munis were yielding as much as 3.4% as recently as mid-May—their highest yield outside of March 2020 in over ten years—and the ten-year muni/Treasury ratio briefly moved above 1.0 times, which was higher than 80% of historical observations dating back to 1980. Both yields and spreads have come down in recent weeks but are still well above levels seen at the start of this year. Additionally, net muni supply is forecast to shrink this year and credit fundamentals are solid thanks to unprecedented federal aid and the strong recovery in tax revenues. In fact, total balances for states—the sum of rainy day funds and year-end balances—reached a record $217 billion in fiscal year 2021, according to NASBO data. Lastly, outflows slowed in July and turned positive in August. The end of previous outflow cycles has typically marked the beginning of a sustained period of strong performance for munis.
That said, the economic and policy backdrop remains challenging, and, while munis look more attractively priced after this year’s sell-off, they are not outright cheap. If the economy enters a recession, muni/Treasury ratios could move much higher. For example, ten-year ratios shot above 2.0 times during the GFC and 4.4 times in early 2020. Strong starting credit fundamentals could help cushion munis if a recession does occur, but munis are still vulnerable even if the United States avoids a recession. Financial conditions have tightened rapidly with the Federal Reserve hiking rates 225 bps this year. Conditions may deteriorate further as the Fed is expected to continue raising rates and accelerate quantitative tightening later this year, which could create a challenging environment for less liquid markets such as munis.
Therefore, while we still believe munis deserve a place in most taxable portfolios, given their tax benefits, we do not recommend investors that are underweight munis relative to policy rush to get back to a full allocation at this time given current market conditions.
* After-tax returns are calculated using the highest marginal income tax rate and long-term capital gains tax rate in each period.