The case for municipal bonds

What are US municipal bonds?

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.

Tax features

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.

Potential attractions for European 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.

Two types of municipal bonds

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.

Favourable liability-matching features

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.

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). 

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.

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.