Municipal bond yields are relatively low, which may make some investors wonder about their attractiveness as an investment. However, we have a favorable outlook on munis for the second half of the year, due to a variety of potential tailwinds, including government fiscal support and technical factors.

Because lower-rate issuers have led performance in the current environment and may continue to do so, we suggest investors consider adding some lower-rated issuers (A/A and BBB/Baa) in moderation to their fixed income portfolios. We also suggest targeting a slightly shorter-than-benchmark duration.

Lower-rated munis have driven outperformance

So far this year, the muni market has outperformed all other highly rated fixed income categories, as you can see in the chart below. The lower-rated part of the muni market has driven the outperformance. For example, the Baa rated portion of the Bloomberg Barclays Municipal Bond Index is up 3.2% for the year, compared with -0.1% for the AAA portion.

Munis have outperformed, driven by stronger returns for the Baa portion

Source: Bloomberg Barclays Indices, as of 5/25/2021 Bloomberg Barclays Municipal Bond Index ("Municipal bonds"), Bloomberg Barclays Municipal Index Taxable Bonds ("Taxable municipal bonds"), Bloomberg Barclays US Aggregate Bond Index ("Core bonds"), Bloomberg Barclays US Corporate Bond Index ("Corporate bonds"), Bloomberg Barclays US Treasury Index ("U.S. Treasuries"), Bloomberg Barclays Municipal BAA Index, Bloomberg Barclays Municipal A Index, Bloomberg Barclays Municipal AA Index, Bloomberg Barclays Municipal AAA Index. Past performance is no guarantee of future results.

Going forward, we think the following factors are supportive of muni returns for the rest of 2021:

1. Substantial fiscal support has eased credit risks. Since March 2020, lawmakers have passed six separate bills totaling about $5.3 trillion—with the most recent one, the American Rescue Plan (ARP), being a game changer. State and local governments will receive $350 billion in direct aid. Higher education will receive $39 billion, public transit will get $40 billion, air carriers and contractors will get $15 billion, and airports will get $8 billion. There are also many other provisions that are supportive of economic growth and indirectly support many muni issuers.

2. The COVID-19 crisis wasn’t as bad as expected for issuers’ financial positions. When the COVID-19 crisis first hit in March 2020, there were concerns that there could be a wave of downgrades and potentially defaults in the muni market. That largely didn’t happen because of the swift and substantial fiscal support, as well as the disproportionate impact the crisis had on the higher- vs. lower-income earners. Income taxes are the primary source of revenues for many states, and because incomes generally did not fall for high-income earners, state revenues held up much better than expected. In fact, since March 2020 through December 2020, revenues for 21 states were higher than in the same period in 2019.

In aggregate, combined state and local government revenues fell slightly less than $1.7 billion for the calendar year 2020. The direct aid will more than replace those lost revenues, as illustrated in the chart below. Even in cases where revenues fell a large amount, like Hawaii, North Dakota, and Alaska, those states are receiving a large amount of aid that will easily backfill those declines. In fact, in no instance are revenues negative after accounting for the direct aid. In other words, the economic fallout wasn’t as bad as expected for certain segments of the economy, and state and local governments are getting a large amount of direct aid, so the risk of defaults and downgrades has declined.

The direct aid from the American Rescue plan will easily backfill revenue declines

Source: Tax Foundation, as of 3/3/2021

3. Technical factors should keep yields from rising too fast. The muni market is relatively unique in that a large amount of coupon and principal payments come due during the summer months and generally needs to be reinvested, yet supply generally does not increase to absorb that demand. This dynamic, known as net negative supply, is an annual occurrence in the muni market, as shown in the chart below.

Net negative supply may keep muni yields from rising more than Treasuries in the near term

Source: Bloomberg, as of 5/27/2021

The municipals-over-bonds (MOB) spread is a common metric used to evaluate the attractiveness of municipal bonds. It is a ratio of the yield on a AAA-rated muni relative to the yield of a Treasury of similar maturity. As of May 28, the five- and 10-year MOB spreads were 56.3% and 61.0%, respectively, well below their 10-year averages of 92% and 96.4%. Usually, we would expect the MOB spreads to return to closer to their averages, and therefore munis should underperform Treasuries.

However, we don’t expect that to happen, because net negative supply poses a headwind to the MOB spreads increasing from these low levels. Since 2001, on average, the months of May, June, and July have accounted for three of the four worst months for the 10-year MOB spread. In other words, the 10-year MOB spread has historically been the lowest during May, June, and July compared with all other months in the same calendar year.

4. The American Rescue Plan is likely to keep supply low. In general, state and local governments are awash with cash due to the substantial fiscal support they’ve received. As a result, it’s unlikely that they will have to borrow and issue bonds to the same degree as they have in the past. We expect that supply will be lower than in years past, which is another reason why yields relative to Treasuries are unlikely to rise significantly, and therefore relative returns for munis should be attractive.

5. Prospects for higher tax rates should also keep yields from rising too fast. It’s unclear if individual or corporate income tax rates will actually go up, but it is clear that the current administration wants them to go up. President Joe Biden has proposed increasing the top individual tax rate to 39.6% from 37%, as well as increasing the corporate tax rate to 28% from 21%, but is open to a lower corporate tax rate than 28%.

Partly because of the prospects for higher taxes, demand for municipal bonds—which are generally exempt from federal and potentially state income taxes—has been very strong. Since April 15, 2020, there have been positive net inflows for 53 out of the 57 weeks for muni mutual funds and exchange-traded funds (ETFs). However, the average visible supply for 2021 has been below both 2019 and 2020, as illustrated in the chart below. The supply/demand imbalance has helped keep relative yields low. In the near term, we don’t anticipate this supply-and-demand imbalance to abate, which should keep muni yields from rising faster than Treasuries.

Supply in 2021 has been below the averages for 2019 and 2020

Source: Bloomberg, as of 5/28/2021

6. Increased taxable issuance is taking out tax-exempt supply. Year to date, roughly 25% of total municipal bond issuance has been taxable munis, meaning bonds that pay interest income that is subject to federal and potentially state income taxes. For comparison, since the start of 2013 roughly 10% of new muni issuance has been taxable. Issuers are generally choosing to issue taxable debt because there are fewer restrictions on what it can be used for and they’re using it to refinance older, higher-yielding debt. This increase in issuance of taxable debt has taken out supply of tax-exempt debt and has weighed on tax-exempt muni yields relative to Treasuries. Going forward, we expect taxable issuance will account for a larger percentage of issuance than historically, which will help keep muni yields from rising faster than Treasuries.

Risks to our view

We believe total returns for munis should fare well compared to other fixed income investments, but there are risks to our view. For example, the uneven recovery could exacerbate the finances of some issuers. The COVID-19 crisis has had a disproportionate impact on parts of the economy, with areas highly reliant on the tourism or travel industry experiencing a more severe financial impact.

Even though the storm clouds of the COVID-19 crisis are clearing, some municipalities are still facing many of the issues they faced before the crisis. For example, unfunded pension liabilities continue to pose a risk to some issuers. Although the aid from the American Rescue Plan more than offset the declines in revenue, it’s worth noting that the money can’t be used for pension contributions.

Finally, a reemergence of the virus poses a risk. The vaccine rollout has gone better than originally anticipated and case counts are down, but a new strain of the virus or an increase in case count could slow the economic recovery.

What to consider now

We expect longer-term rates to drift modestly higher this year. Longer-term bonds are more sensitive to interest rates relative to short-term bonds, so we suggest investors target a slightly shorter-than-benchmark duration, which will help limit the impact of rising rates. Duration is a measure of interest rate sensitivity. For reference, the duration of the Bloomberg Barclays Municipal Bond Index, a commonly tracked benchmark, is about 4.8 years, so a duration of 3.0 to 4.5 years can be appropriate depending on an investors risk tolerance and needs.

For investors using individual bonds, a strategy we like is a bond ladder. With a ladder, you invest equal amounts in equally spaced rungs to help spread the interest rate risk. In terms of what maturities to invest in, first consider your needs and risk tolerance. Between one year and nine years offers the highest yield per unit of duration, as illustrated in the chart below. Yield per unit of duration can be considered a measure of risk relative to reward. (Investors researching mutual funds and ETFs can view the duration of the fund on the summary page for the mutual fund or ETF on Schwab.com.)

The yield per unit of duration peaks at nine years

Source: Bloomberg AAA BVAL curve, as of 5/28/2021. “Duration” is the modified duration assuming a 5% coupon and semi-annual coupon payments.

We suggest that investors moderately add some lower-rated issuers to their portfolio. However, we would caution against adding too much, as they are still prone to more volatility relative to higher-rated issuers. As a rough starting point, we would suggest putting no more than 40% of a muni portfolio in BBB/Baa and A/A rated issuers. Consider these weightings a foundation, and deviate from them based on your own personal risk tolerance and needs. For reference, the Bloomberg Barclays Muni Bond Index is 16% Aaa, 50% Aa, 26% A, and 9% Baa.

There are a few different ways investors can add lower-rated issuers to their muni portfolios.

• Add A/A and/or Baa/BBB rated individual bonds. Schwab clients can log in and search for individual bonds on the “Research” -> “Bonds & Fixed Income” -> “Find Bonds & Fixed Income” tab by selecting BBB and/or Baa2 in the drop-down menus in the ratings section. We would suggest extra scrutiny on BBB- and Baa3 rated munis, as that’s the lowest rung before “junk” (or below investment-grade). Before adding lower-rated issuers, we would suggest evaluating the credit composition of your existing portfolio to ensure that you’re not adding too much additional risk.
• Invest in a mutual fund or exchange-traded fund (ETF). Schwab clients can view the credit ratings of muni mutual funds and ETFs under the “Credit Ratings” section of the “Portfolio” tab on the ETF or mutual fund description page. For help getting started with an appropriate ETF or mutual fund, consider using the Schwab Mutual Fund or ETF Select List which is a list of pre-screened mutual funds and ETFs.
• Invest in a separately managed account. A separately managed account, or SMA, is a portfolio of individual securities, such as stocks or bonds, that is managed on your behalf by a professional asset management firm. Unlike with a mutual fund or exchange-traded fund, you directly own the individual securities. More information can be found on the “Managed Account Select” page on the “Products” tab.

These are just a few ideas to get started and not an exhaustive list. For help selecting the right investment for your needs, consider reaching out to a Schwab representative.