With the Federal Reserve expected to trim rates three times in 2024, fixed income investors are looking to the municipal bond space as they prepare to eventually reach for yield. The 10-year Treasury yield is trading at about 4.14%, which is higher than where the benchmark yield ended 2023, but still far off from the October highs when it touched 5%. To prepare for a regime of falling yields, investors can snap up municipal bonds and take a step down in credit quality. “We think it makes sense to lock in rates where they are now, which is still historically pretty high, so that you don’t have to worry about reinvestment risk,” said Jennifer Johnston, director of municipal bond research at Franklin Templeton. “We definitely think it makes sense to go a little lower in credit quality on an overall basis, especially if you compare munis to high grade corporates – munis are far less risky,” she added. Indeed, investors get paid for taking a small step down in credit quality in the muni bond space. Moving down from a AAA-rated muni to an A-rated issue could generate about 50 basis points of additional yield, according to Lyle Fitterer, senior portfolio manager overseeing Baird’s Strategic Municipal Bond Fund (BSNSX). Stepping even lower, to a BBB-rated issue, could generate more than 100 basis points of additional yield compared to what you’d find on a muni bond with a sterling AAA rating, he said. One basis point is equal to one one-hundredth of a percent (0.01%). “In an environment where yields are 2.5%, half of a percent can add a lot of value over time, and that’s a simple buy-and-hold strategy when you talk about excess return,” he said. What’s even sweeter is that municipal bond income is generally exempt from federal income tax. It may also be exempt from state and local taxes if the investor is a resident of the state where it was issued. This also means high income investors would have to scoop up a higher yielding corporate bond to get the same tax-advantaged yield a muni bond would generate. Consider that an investor in the 32% income tax bracket would have to find a taxable corporate bond yielding 4.41% in order to match the 3% yield they would obtain from a tax-free muni, according to New York Life Investments . A measured amount of risk Munis offer lower yields compared to their corporate counterparts, but they also carry significantly less risk. A 2022 analysis from Moody’s Investors Service found that AAA-rated munis had a cumulative 10-year default rate of zero, while similarly rated corporates had a default rate of 0.35%. Going down to the A-rated issues, corporates had a 10-year default rate of 1.96%, compared to munis’ 0.10%. Lower risk, however, doesn’t necessarily mean risk free. For instance, about half of Americans live in states that are pointing to short-term budget gaps, long-term deficits, or both, according to Pew Charitable Trusts , which cited budget analyses states published late last year. A shortfall in income and sales tax revenue could put municipalities under pressure. “States are reporting budget deficits and finding ways to fill them, but I don’t think that’s a major negative going forward,” said Cooper Howard, lead muni bond strategist at the Schwab Center for Financial Research. Finding additional yield In pursuit of higher muni bond yield, charter schools might be an attractive place to go digging, according to Jonathan Mondillo, head of U.S. fixed income at Abrdn. “The issuance is in that cuspy BB-rated category, but it carries a lot of investment-grade characteristics,” he said of charter schools. Higher education is another place to go searching for sweetened yield and slightly higher risk, particularly in the event of an economic downturn. “When you see unemployment numbers tick up, you see a reinvestment in education,” said Mondillo. “You see people go back to school and try to add to their skillset.” The health-care space is an area to watch, as hospitals had been facing pressures from expenses, difficulties finding nurses and the roll-off of pandemic-era aid, said Franklin Templeton’s Johnston. “We are carefully watching how hospitals are addressing community needs,” she said. “We are spending extra time doing due diligence in that sector.”
This story originally appeared on CNBC
