Recent weeks have seen a massive global bond rally on growing optimism the Federal Reserve has nearly finished hiking interest rates and will soon have to hit pause on its tightening regime.
Just look at what has happened in the normally very quiet world of municipal bonds.
Spoilers: there’s still time to get in…
Munis are issued by state and local governments, and generally pay tax-exempt interest at the federal, and potentially state levels.
The proceeds from municipal debt fund a wide range of state and local infrastructure projects, including schools, hospitals, universities, airports, bridges, and highways, as well as water and sewer systems.
Muni Bonds Are Hot
Municipal bond trading soared to an all-time high in November, as retail investors snapped up bonds, driving the market’s best month of performance since the 1980s. Muni bonds posted a 6.3% return in November, the best month of returns since 1982.
There were 1.5 million trades in November, which was a monthly record, according to the Municipal Securities Rulemaking Board. The regulator said that demand from small investors was a major factor in the spike in trading.
This led to, in November alone, AAA benchmark yields dropping more than 90 basis points depending on the maturity, according to Bloomberg data.
This swift, surprising surge has been enough to lift returns and erase losses. The Bloomberg muni index is now up over 3% for the year, a rebound from a loss of 2.2% at the end of October. Benchmark yields for muni bonds due in 10 years and rated AAA are now down to 2.6%, their lowest since April 2023. A very low supply of new bond sales from state and local governments has provided an additional lift for the muni market.
When returns turn positive, municipal bond funds begin to see investor cash come back. For example, investors added about $292 million to municipal-bond funds during the week that ended November 22—marking a reversal from 11 consecutive weeks of outflows—according to LSEG Lipper Global Fund Flows data.
While December may not have as much momentum as November did, the last month of the year has tended to stay in the green. December muni returns have been positive since 2014, according to Bloomberg Intelligence.
The return for November is creating a bit of buzz for this often-overlooked asset class. Karen Altamirano, an analyst with Bloomberg Intelligence, said in a report: “The tremendous reversal of fortune and subsequent run of wins has muni buyers tripping over themselves.”
But be careful, and don’t just pay any price for munis. A similar November trend has played out in the previous two years. After three months of losses from August through October, munis rallied in November in both 2021 and 2022. Last year, the end-of-year gains were due to—you guessed it—increasing expectations that the Federal Reserve would cut rates in 2023, which obviously did not occur.
However, the fundamentals in the municipal bond market are solid.
Credit remains strong, with historic levels of rainy-day funds. While revenue collections are solid and above 2021 levels, they have slipped below the peaks witnessed in 2022. Nevertheless, expect municipal defaults to remain low, rare, and idiosyncratic.
Why Buy Muni Bonds?
One main reason munis make sense to me is that many issuers have a monopoly over their services and don’t face competition like corporations do.
An even better reason is that issuers are often backed by durable revenue sources such as taxes. As a result, defaults tend to be rare, even during recessionary periods. For example, during the financial crisis of 2007–2009, only 12 rated issuers defaulted, compared with 414 corporate bonds of similar credit quality.
Currently, many muni issuers are financially strong. In fact, the balances of the aforementioned rainy-day funds—money states set aside to use during unexpected deficits—are at near-record levels. Even Illinois, the lowest-rated state in the muni market, had a rainy-day fund balance of more than $600 million in 2022, compared with just $4.15 million in 2020.
Also keep in mind that muni bonds generally have strong credit ratings—usually higher than corporate bonds. Nearly 70% of the Bloomberg Municipal Bond Index is rated in the two highest categories, compared with just 8% of those in the Bloomberg Corporate Bond Index.
How to Buy Munis
Your best bet may be to buy individual munis tailored to your specific financial situation. All the major brokerages have bond specialists that can do this for you.
However, there are municipal bond mutual funds and ETFs that you can buy online in your brokerage account. Here are two examples…
The first muni bond ETF that’s really interesting to me is the Xtrackers Municipal Infrastructure Revenue Bond ETF (RVNU). This fund tracks an index of investment-grade municipal bonds backed by revenues from local infrastructure projects such as airports, toll roads, and water and sewer.
Its portfolio is allocated this way:
- Transportation: 32.73%
- Airport: 29.95%
- Water: 12.80%
- Utilities: 7.42%
- Power: 7.19%
- Other: 9.91%.
Keep in mind, though, that since it is focused on just one segment—infrastructure—it may be more volatile. The fund is up 4.3% year-to-date and has an expense ratio of just 0.15%. The total return over the past year was 5.33%. The 30-day SEC yield is 4.01% and pays distributions monthly.
If you’re looking for broader exposure to the muni market, one of the largest ETFs is the Vanguard Tax-Exempt Bond ETF (VTEB). The investment objective of this index fund is to track the performance of a benchmark index that measures the investment-grade segment of the U.S. municipal bond market.
As is typical for Vanguard ETFs, its expense ratio is a miniscule 0.05%.
The fund is up just 1.29% year-to-date. Its total return over the past year is 3.10%. Its 30-day SEC yield is 3.63% and pays distributions monthly.
