The Appeal of Muni Bonds During a Recession

Between intense market volatility and wavering consumer confidence, the economy appears to be slowing down. For concerned investors, municipal bonds, a.k.a. munis—which are issued by state and local governments, and generally pay tax-exempt interest at the federal and potentially state levels—can be particularly attractive during periods of economic decline. Here are three reasons they may make sense now.

On the whole, muni bonds tend to be more highly rated than corporate bonds. Indeed, nearly 70% of the bonds in the Bloomberg Municipal Bond Index are rated in the two highest categories, compared with just 8% of those in the Bloomberg Corporate Bond Index.

One reason is that many muni issuers have a monopoly over their services and don't have to compete for customers like corporations do. Another is that issuers are backed by durable revenue sources such as taxes.

As a result, defaults tend to be rare—even when looking exclusively at recessionary periods. For example, during the Great Recession of 2007–2009, only 12 rated issuers defaulted¹—compared with 414 corporate bonds of similar credit quality.²

Fiscal conditions for most state and local governments are strong due to substantial pandemic-related support from the federal government, and that's on top of recently surging tax revenues.

In fact, the balances of so-called rainy-day funds—money that states set aside to use during unexpected deficits—are at near-record levels. Even Illinois, the lowest-rated state in the muni market according to major ratings agencies, had a rainy-day fund balance of more than $600 million in 2022, compared with just $4.15 million in 2020.

While it's true that a recession often coincides with a slowdown in consumer spending and an increase in unemployment, many tax revenues aren't affected until long after a recession begins. For example, tax revenues remained relatively steady early in the 2007–2009 recession and didn't start substantially declining until 2010. But they quickly rebounded, which is likely one reason why so few munis defaulted during this period.

In four of the past five recessions, munis posted positive total returns over the 12 months following the start of a downturn. Only during the 2007–2009 recession, when most asset classes trended downward due to the global credit crisis, did munis post a negative return over the same time frame.

However, it's important to remember that each recession is the result of unique market dynamics that may or may not play out this time around. For example:

• The 1981 recession, during which munis saw a 10% total return after the start of the downturn, was characterized by the Federal Reserve aggressively hiking interest rates to quash record-high inflation—a situation that somewhat resembles the recent economic environment.
• In both the 1990 and 2001 recessions, munis posted positive total returns because yields were already moving lower and continued that trend as investors sought less volatile investments. By contrast, today's muni yields are the highest they've been in more than a decade.
• The 2020 recession, driven by global lockdowns amid the COVID-19 pandemic, bears no comparison to any modern downturn.

Regardless of the economy's direction, muni bonds can be appealing thanks to their tax-advantaged income. Investors looking to add munis now should focus on those from highly rated issuers, which historically have held up well during economic declines, and should help insulate their bond portfolios if a recession does come to pass.