Market change drives new
interest in US muni bonds

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November 2, 2021

What appeal could the US municipal bonds hold for institutional investors? Here, Jefferey Burger, portfolio manager municipal bonds, at Insight Investment, makes a case for this opportunity-rich asset class.

Insight portfolio manager Jeffrey Burger is keen to raise investment awareness among overseas investors unfamiliar with US municipal bonds. He considers issuers of municipal bonds such as US states and local governments to be “perpetual ongoing concerns and natural monopolies”— which can provide both yield and a low risk profile.

Like many investors, Burger wonders what a post–Covid economy will look like. Markets are already seeing the concerns of inflation and rising interest rates take their effect on uneasy investors as they potentially shift into asset classes which historically have had no correlation to municipal bonds, such as equities.

“We believe that the municipal bond asset class is well-positioned to help reduce risks in an uncertain future,” says Burger.

But just what can municipal bonds offer investors?

Burger cites:

  • High credit quality, especially compared to corporate securities
  • Limited price volatility—particularly important given the unknowns in the fixed-income world going forward
  • A large, diverse market
  • Heterogeneous security-specific exposure—diversification across the entire US
  • Solvency scoring—municipal bonds score well
  • Income component—attractive relative to US Treasuries and corporates
  • Correlation benefits—strong diversifier to risk exposure

Further, in the US Federal Reserve (Fed) tightening cycle we’re most likely about to see, municipal bonds, as a fixed-income instrument, have historically outperformed other asset classes while under interest-rate pressures. “When interest rates rise, there’s more tax advantage to municipal bonds,” says Burger. “And as taxes may go up, there may be more demand for this asset class.”

“From a thematic perspective,” Burger adds, “municipal bonds provide investors an opportunity to invest in infrastructure with fixed-income returns and lower risks”—just at the same time there is a major government push to invest broadly in US infrastructure. In effect, this means the government will subsidize debt service for municipalities by offsetting costs.

Municipal bonds are the primary funding source for US infrastructure—as opposed to private capital or the government. The types of projects that municipal bonds finance are core infrastructure in areas such as transportation, energy, water, and social infrastructure—which centres on the construction and maintenance of facilities that support social services such as health care, education, housing.

What other attractions do municipal bonds hold? They occupy a large market, nearly US$4 trillion in size. There are more than 55,000 issuers (eight times that of the corporate bond market). “With that many issuers,” Burger says, “it can lead to inefficiency. And from an inefficient perspective, from where investors sit, that means opportunity.”

There also is a lack of institutional penetration in the market, with72% of it comprised of retail investors, who receive favorable tax treatment for owning a municipal bond.

“The yield advantage of owning a municipal bond is also still there, compared to corporates, US Treasuries, and sovereign debt across the world. In some ways, this isn’t even a fair comparison,” Burger says, “because the US double-A corporate market is extremely small at this point, with most US corporates at triple-B. So, to get a similar yield in the corporate world relative to municipals, you really have to go down the credit curve.”

A distinction among municipal bond funds (besides whether the bonds themselves are general obligation or revenue) is that some funds are tax-free (which offer a lower yield) and others are taxable (which owing to a tax-code change offers higher yield).

“What that change means the investor, is that he or she has the opportunity to enter into this high-quality market with higher yield than investors would have had prior to the tax reform,” he concludes.

All investments involve some level of risk, including loss of principal. Certain investments have specific or unique risks.

Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines.

Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.

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