7 Reasons to Consider Municipal Bonds Now

For investors in higher tax brackets, we believe that municipal bonds currently offer a compelling balance of risk and reward. Yields for these often tax-exempt fixed income securities are at attractive levels even as interest rates in general appear to be headed lower. Also, the credit quality of many municipal bond issuers' has improved recently as measured by their credit ratings. This suggests they have a strong ability to make timely interest payments.

For fixed income investors who have been heavily invested in cash, cash alternatives, or very short-term investments we suggest considering  moving out the yield curve and locking in attractive tax-advantaged yields in the municipal bond market.

Municipal bonds, or munis, are issued by a city, state, or local government. Generally, municipal securities pay interest income that is exempt from federal income taxes and may also be exempt from state income taxes if purchased from issuers in your home state. Mostly due to their tax benefits, munis yield less than comparable bonds that are subject to income taxes. However, after considering the impact of taxes, they may yield more. For example, consider a municipal bond that yields 3.3% compared to a fully taxable corporate bond that yields 4.7%. For bondholders in the 32% and above tax brackets, a muni may yield more after considering the impact of federal, state, and other taxes. Even for an investor in the 22% or 24% tax brackets, the yields are about the same after taxes.

In addition to the tax benefits that munis currently offer, here are seven reasons why we suggest some investors should consider adding munis to their bond portfolios now.

Although yields have fallen from their highs of about a year ago, they are still at attractive levels, in our view. For example, the yield to worst (the lowest possible yield that can be received on a bond with an early retirement provision barring default) on the broad Bloomberg Municipal Bond Index is roughly 3.3%. For an investor in the top federal tax bracket in a high-tax state, like California or New York, that's equivalent to a 6.8% yield for a fully taxable bond.

Not only are absolute yields attractive but when compared to other bonds with similar credit ratings and maturities, munis look attractive. For example, a metric that we regularly follow is the muni-to-Treasury ratio, which is the ratio of the yield on a AAA rated¹ muni compared to a Treasury of similar maturity before adjusting for taxes. From the end of 2023 through the middle of this year, the 10-year muni to Treasury ratio hovered below 65%. It then rose above 70% which is above its one-year average and close to its three-year average, before dropping to 69.4% as of September 25, 2024. Ratios for shorter-term maturities, like two and five years, have also improved recently and are above their three-year averages.

At the conclusion of the September meeting of the Federal Open Market Committee (FOMC), the Federal Reserve cut its benchmark policy rate by 50 basis points (bps), or 0.50%, and signaled the potential for another 50 bps of cuts this year and 100 bps of cuts in 2025. The magnitude and speed of rate cuts will depend on the outlook for the economy but the path forward is pretty clear—the Fed is poised to further cut interest rates.

As the Fed cuts rates, it's likely that yields for short-term fixed income investments will move lower. This has implications for investors who have been holding large allocations to cash or short-term investments in place of longer-term bonds. Since absolute yields are still relatively attractive in our view, we believe investors who have been focusing on short-term investments should still consider adding some intermediate-term muni bonds as an opportunity to lock in those yields.

Bond prices and yields typically move in opposite directions. So historically, when the Fed lowers rates it leads to higher prices on bonds, and therefore positive total returns for munis. While each rate-cutting cycle over the past three-plus decades has been unique, munis have delivered positive 12-month total returns in five of the last seven rate-cutting cycles. Only in the cycles that started in 1998 and 2007 did munis deliver negative total returns over the subsequent 12 months.

Going forward, the upside for longer-term yields is limited in our view, which is supportive of positive total returns. Even if rates do move higher, and prices lower, some of the decline in price may be made up by the coupon income, which is higher now than it has been recently.

Shortly after the pandemic started, expectations were that revenues for most state and local governments would be negatively impacted and the ability for most municipalities to meet their debt service would suffer. That never happened. Instead, tax revenues surged and fiscal aid flowed in like the Colorado River. As a result of the substantial fiscal aid and surge in tax revenues, many state and local governments found themselves in a better financial position than they were prior to the pandemic. In fact, Moody's Investors Service has upgraded more issuers than they've downgraded over the past 14 quarters. That's the longest streak of upgrades relative to downgrades since the fourth quarter of 2008. As a result, the share of highly rated munis in the index has increased to over 70%.

In other words, not only are yields high, in our view, but credit quality is also high. Generally, higher credit ratings result in lower yields, but that's not the case with munis today. Investors are now being better compensated for taking less credit risk than they have been at any point during the past 15 years.

In addition to the recent upward trend, most munis have exhibited a history of strong credit quality. This has historically led to a very high probability of being able to pay the scheduled interest and principal payments on the bonds issued. For example, out of 1,000 municipal bonds, only one investment-grade-rated issuer has defaulted over a 10-year period, according to Moody's Investors Service. This compares with an average of 22 investment-grade-rated corporate bonds under the same criteria. A caveat is that these default statistics are based on historical averages, but going forward, we expect defaults to be rare and munis to continue to exhibit strong credit stability.

A municipal bond allocation also can help reduce the downside of a portfolio. For example, the average annual return for a hypothetical portfolio that was allocated 80% to munis and the rest to the S&P 500^® from 1990 through 2023 would have experienced an average annual return of 6.3% This compares to an average annual return of 9.4% for a portfolio that was invested in 20% munis and 80% equities. Although the portfolio that was allocated more to equities experienced a higher average annual return, it also experienced much more dramatic annual highs and lows.

This is important for investors who are using their portfolios for retirement income or to help support their lifestyle because having to sell securities when the market is down can have devastating consequences on a portfolio that is taking withdrawals.

For example, consider two hypothetical portfolios held by investors who withdraw 4% each year. 4% is a fairly safe first-year withdrawal rate for a retirement portfolio. We suggest creating a plan to get a personalized spending rate but for simplicity purposes, we are using 4% here. Portfolio 1 is more conservatively invested and experiences a modest 5% drop in a year. Portfolio 2 is more aggressively invested and experiences a 25% drop over the same time period. For Portfolio 1 to generate the same income, the withdrawal rate in year 2 would need to increase to 4.4% vs. 5.6% for Portfolio 2. A 4.4% withdrawal rate is still generally viewed as a safe withdrawal rate whereas a 5.6% withdrawal rate is not.

We believe the case for municipal bonds for investors in higher tax brackets is strong now. Yields are attractive and credit quality has improved over the past couple of years. However, there may be hiccups going forward and some areas of the municipal bond market are starting to show cracks. We think investors should consider adding some intermediate-term munis to lock in yields before the Fed cuts rates further. For help selecting the right investments for your needs, consider reaching out to a Schwab representative or reviewing the resources available on Schwab.com.