Municipal bonds have played a vital role in building America’s infrastructure. They were a major source of financing for canals, roads, and railroads during the country’s westward expansion in the 1800s, and today, they fund a wide range of state and local infrastructure projects, including schools, hospitals, universities, airports, bridges, highways and water and sewer systems.
Municipal bonds are issued by US state and local governments (municipalities), eligible not-for-profit corporations and territories and possessions of the US (for example, American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the US Virgin Islands). When an investor purchases a municipal bond, he or she is lending money to finance a myriad of public projects.
Municipal bond interest payments are typically exempt from US federal income taxes, and sometimes state income taxes for US domestic investors.
For investors who do not pay taxes in the US, these tax features might be considered a drawback rather than an advantage since nominal yields are driven down by investors who can utilise tax deductions.
This is why foreign investors usually focus on taxable portion of the municipal market. Taxable municipal bonds tend to offer higher risk-adjusted yields comparable to those available on other taxable issues, such as corporate bonds.
The taxable municipal bond market represents over USD760 billion of the total municipal market (approximately 21% of the overall municipal bond market), with over 3,000 issuers.1
Issuers may choose to issue a taxable municipal bond for a variety of reasons, including access to a broader investor base, the flexible use of proceeds and the fact that the financed activity is not considered tax-exempt.
Issuers of municipal bonds can also issue debt using corporate CUSIPs1. This has created a sub-class of municipal bonds that use a corporate CUSIP identifier. The aim is to take advantage of the greater liquidity and diverse investor base offered by the corporate market. Typically, municipal issuers access the corporate bond market to issue longer-dated structures that are attractive to liability-driven investors.
US municipal bonds are also considered a source of long-dated, high credit quality fixed income and a source of potential diversification within existing credit portfolios.
They also provide access to US infrastructure debt in a publicly available form (revenue bonds) and offer potentially higher yields than similarly rated public credit, with a history of lower default rates and higher recovery rates.
In addition, we believe they are often worth considering for their attractive relative value compared to European corporate bonds, even after hedging costs.
Municipal bonds generally fall into one of two categories: general obligation bonds or revenue bonds. The primary distinction between the two is the source of revenue that secures the bonds.
General obligation bonds at the state level are secured by the state government’s pledge to use all legally available resources to repay the bond.
Examples of issuers of general obligation bonds include states, cities, counties, and school districts.
Revenue bonds are secured by a specific source of revenue earmarked exclusively for repayment of the revenue bond. Water and sewer authorities, electric utilities, airports, toll roads, hospitals, universities, and other not-for-profit entities typically issue these bonds to finance infrastructure projects.
There are many features of typical municipal bonds that make them an instrument worthy of consideration for matching long-term liabilities. Key features when compared to global corporate bonds include, ratings stability (Figure 1), lower default rates, higher recovery rates and more predictable long-term income.
The rating drift is the ratio of difference of the aggregate rating upgrades and downgrades to the number of companies rated at the time of the beginning of the period
Source: Moody's Investors Service – July 2023
Most state and local governments are highly rated, whereas corporate credits tend to have lower average ratings. The median rating of municipal issuers is Aa3, compared to Baa3 for global corporates.
Accordingly, it is not surprising that municipal default rates have been extremely low, especially when compared to global default rates. The global corporate investment grade default rate is more than 24 times higher than the municipal investment grade default rate. The 10-year average cumulative default rate for high yield global corporate bonds is more than four times higher than the high-yield municipal bond default rate (Figure 2).
| Municipal Bonds | Corporate Bonds |
|
Aaa |
0.00 |
0.34 |
Aa |
0.02 |
0.75 |
A |
0.10 |
1.90 |
Baa |
1.05 |
3.64 |
Ba |
3.31 |
15.82 |
B |
16.65 |
34.66 |
Caa-C |
23.58 |
47.92 |
Investment-Grade |
0.09 |
2.23 |
Speculative-Grade |
6.84 |
29.81 |
| All Rated | 0.15 | 10.72 |
Source: Moody’s Investor Service, 19 July 2023: US Municipal Bond Defaults and Recoveries, 1970-2022.
Past performance is not a guide to future returns.
Looking at the universe of taxable municipal bonds, Figure 3 compares outstanding issues with municipal CUSIPs2 to those with corporate CUSIPs. The maturity structure of both sets of bonds is tilted toward the longer end, with the bias for longer-maturity structures stronger in corporate CUSIP securities. This shows the availability of longer-maturity bonds to match longer-dated liabilities. In addition, taxable municipal bonds are typically noncallable, which is favourable for liability-matching purposes.
Source: Bloomberg, JP Morgan, 29 February 2024. Fixed and zero coupon only. Notes excluded.
The Invesco Municipals Team has been managing municipal strategies for 47 years. Our team of experienced analysts and portfolio managers manage a wide range of strategies from ETFs to mutual funds. With over 60 advanced degrees and designations, we believe our team provides keen judgment to help identify the best potential opportunities for our clients.
Source: Bloomberg – 31 March 2024
A CUSIP (Committee on Uniform Securities Identification Procedures) number is a unique identification number issued to stocks and registered bonds in the United States and Canada.
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
The creditworthiness of the debt municipal bonds are exposed to may weaken and result in fluctuations in the value of the strategy. There is no guarantee the issuers of debt will repay the interest and capital on the redemption date. The risk is higher when the strategy is exposed to high yield debt securities.
Changes in interest rates will result in fluctuations in the value of the strategies invested in municipal bonds.
Municipal bonds may be exposed to the risk of the borrower defaulting on its obligation to return the securities at the end of the loan period and of being unable to sell the collateral provided to it if the borrower defaults.
Municipal bond investments might be concentrated in a specific region or sector or be exposed to a limited number of positions, which might result in greater fluctuations in value than for a more diversified investments.
Views and opinions are based on current market conditions and are subject to change.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
EMEA 3639602/2024
