Investors flock to municipal bonds for yield and shelter

As the U.S. economy continues to emerge from the effects of the Covid-19 pandemic, municipal bonds have become the darling of financial advisers and asset allocators.

Through June 9, flows into muni bond mutual funds and exchange-traded funds topped $53 billion, which equals the total flows into the category for all last year. Considering that muni bond fund flows were at $50.5 billion through the first six months of 2019, it’s safe to assume the category is back on track with bullish support for a host of reasons.

Jordan Benold, financial adviser at Benold Financial Planning, attributed the growing appeal to safety and concerns over higher taxes.

“Muni bonds have experienced historically low default rates,” he said. “The second reason is the threat of increasing income taxes. Not only will the current income taxes sunset in 2025, but the new administration wants to raise the capital gains rate. Investors invest in muni bonds so the interest income is not taxable.”

The federal government deserves a lot of the credit for the recent muni market boom, said Paul Winter, founder of Five Seasons Financial Planning.

“The higher the tax rates that investors experience, the greater the appeal of the tax-free muni-bond interest income becomes,” Winter said. “And during the Covid crisis, the Fed stepped in to buy muni bonds, and I'm sure this is viewed by some as an implicit backstop on yield spreads between munis and Treasuries.”

Ronald Bernardi, president and chief executive of Bernardi Securities, said low yields across the board are also driving investors toward the tax-exempt income of muni bonds. “If you’re in a 35% or 39% tax bracket, earning 1.5% tax free is compelling relative to the 10-year Treasury at 1.5%,” he said.

But another factor driving the appeal of muni bonds, Bernardi added, is the relative health of most state and local governments, a situation that stands in stark contrast to the outlook during the early days of pandemic.

“It’s not lost on investors from a credit perspective how well-run state and local governments have come through this,” he said, adding that even poorly run local governments are now in better shape than they were before the federal government started sending bailout money.

“Entities that came into March of last year financially challenged remain financially challenged, but they’ve been thrown a lifeline,” Bernardi said. “But well-run state and local governments that went into March of last year in good shape are in very good shape today. And that is a wide swath because there are many more well-run state and local governments than poorly run ones.”

Lawrence Gillum, fixed-income strategist at LPL Financial, views the muni story as one of relative strength, especially compared to March 2020, when more than $44 billion flowed out of the category. For context, March 2020 saw outflows across stock and bond funds, and only the commodity fund category had net inflows.

“That was a case of investors shooting first and asking questions later,” said Todd Rosenbluth, director of mutual fund and ETF research at CFRA.

“We’ve certainly seen the recovery in local economies as we’ve made our way to hopefully later stages of the pandemic, and states seem to be in better shape than people had feared,” Rosenbluth added.

While Gillum appreciates the fact that many state and local governments are suddenly flush with federal aid, there is still the lingering reality that state pension plans are only about 70% funded.

“Nonetheless, with strong tax revenues, billions in federal aid and strong flows into the market, municipal bonds should remain well bid, particularly in the near term,” he said.

David Hammer, head of the municipal bond portfolio management team at Pimco, said municipal bonds “didn’t recover as quickly as other asset classes last year,” which is part of the reason they look so strong now.

Investors' fears, he explained, related to the potential risks facing issuers such as not-for-profit health care systems and public transportation systems, which were seen as being at extreme risk of negative economic fallout from the pandemic.

“Last year there was fear of the unknown and the fact many sectors in the muni market were directly affected by the nature of the pandemic,” Hammer said. “State and local governments were projecting huge budget deficits. But what made muni markets resilient is the fact that many munis are monopolistic, and the federal government stepped in and supported some of the most adversely affected credits.”