Why Muni Bonds Are a Good Investment Play

Debbie Carlson

Despite the yield curve inversion in two- and 10-year Treasury bonds, there are plenty of opportunities for investors to earn stable yield, including municipal bonds, experts say.

Municipal bonds, in general, are performing well, supported by favorable supply and demand dynamics, and it's expected to continue.

July marked nine straight months of municipal bonds' strong performance, according to a research note from BlackRock, an investment management company. The S&P Municipal Bond Index was up 0.77% in July, bringing the year-to-date return to 5.75%.

It's been a strong year for total return on fixed-income investments in general. One of the major advantages of munis is that these bonds are typically exempt from federal income tax.

Demand for municipal bonds specifically benefited from the 2017 tax code changes because they are tax-free in certain circumstances. The reform eliminated some tax deductions, which increased demand by people who live in high-income-tax states such as California, New York and New Jersey.

That's made California municipal bonds and New York municipal bonds some of the most highly-sought bonds, especially among those in higher tax rate bracket. This year's demand for municipal bonds means yields for these instruments have fallen, which is noticed in the fixed-income market. That's because in the bond market, price and yield move inversely.

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Municipal bonds and fixed-income yields may continue to fall as investors seek safe-haven investments and the Federal Reserve is lowering interest rates. Despite lower yields, municipal bonds' tax-free benefit them a preferred choice over other debt instruments, fixed-income watchers say. Here are a few trends when it comes to investing with these bonds:

-- Municipal bonds are worth the higher price.

-- Municipal bond are still a preferred choice.

-- Time to lighten up on high-yield bonds.

Municipal Bonds Are Worth the Higher Price

Municipal bond prices are higher for three reasons this year: strong demand, historically low global interest rates and little new supply.

The municipal bond market first saw demand from people seeking tax-free income. Now additional demand comes from investors rebalancing out of expensive stocks after more than a decade of a bull market. International investors seek the higher U.S. yields versus other parts of the world, says Lyman Howard, portfolio manager at Ashfield Capital Partners.

"There is north of $10 trillion globally [in bonds] that yields zero percent or less," Howard says, making the 10-year note Treasury yield of 1.5% appealing.

New municipal bond supply isn't keeping up with demand. Howard says many state and local municipalities haven't embarked on the type of spending that would require new bond issues. When municipalities do issue new bonds, those are usually old debt refinanced at lower interest rates.

"The supply dynamic can be slow to change unless there's a flood of new issuance around the corner, and that doesn't seem likely," Howard says.

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That shows this is a demand-driven market, experts say.

Jim Barnes, director of fixed income at Bryn Mawr Trust, says there hasn't been much fundamental economic change by states. "A lot of the states may have more money in their coffers because they were able to take in more tax revenue, but it's really not a fundamental story," Barnes says.

Municipal Bonds Are Still a Preferred Choice

There are no bargains in municipal bonds and that shouldn't change much, Howard says. "You kind of have to hold your nose and just buy here," he says.

According to Barnes, the demand for these instruments will stay strong as people want to lower their tax bills. But demand may soften a bit from the early-year buying rush, which could make these bonds a bit cheaper.

With the Federal Reserve's recent interest rate cut, Barnes expects investors will take on longer-dated debt. Last year most investors were in the shorter-end of the yield curve, buying bonds with a duration of one to five years because they were skittish about the price risk as interest rates drifted higher.

"If interest rates stay low, investors aren't as sensitive as they were when the interest rates going up," he says. "Investors can continue to extend out on the yield curve, which should further support municipal bond demand across the curve for the remainder of this year."

Lighten Up on High-Yield Bonds

Lyle Fitterer and Duane McAllister, co-managers of two municipal bond funds at Baird Advisors, say municipal bond supplies may start to become more plentiful which could lower prices and boost yields. Fitterer says historically there is a pickup in governments issuing new supply in September and October, and the drop in interest rates may accelerate those auctions.

"It might be a fairly good time for people looking to put some money to work if they've been sitting on the sidelines because of the supply and demand balance," Fitterer says.

McAllister says Baird is focused on higher-quality credit and not seeking out a lot of excess credit risk because they believe the economic cycle is in its later stages. Spreads between lower quality and higher-quality bonds have tightened, so McAllister doesn't believe investors will be compensated for the extra risk by buying lower-quality bonds.

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Howard says is also sticking with higher-quality bonds for his clients, even if it means receiving a lower yield. "The reason to own municipals is for safety, stability of cash flows, portfolio balance and to earn a rate of return that doesn't impact your taxable income," he says. "For that reason, we're not trying to shoot out the lights on riskier munis."

While Baird's team is lightening up on high-yield bonds, also known as junk bonds, investors with a different economic outlook may be comfortable with lower-quality bonds, Fitterer says.

"If you're in a world where you're concerned about volatility increasing, and you think we're closer to the end of that economic cycle, then you'll probably want to get a little bit more conservative a little more quickly," he says.

Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.