Tax-efficient muni bond opportunities

Key takeaways:

• Municipal bonds have been a classic asset class for investors looking to pursue tax-advantaged income.
• With tax-equivalent yields that are now higher than taxable fixed income, rising muni bond yields may create opportunity for investors.
• We examine the case for munis now and the role they can play in portfolios.

With tax-equivalent yields that are now higher than taxable fixed income, rising municipal bond yields may create opportunity for investors. Sean Carney, Head of Municipal Strategy, and Karen Veraa, Head of iShares U.S. Fixed Income Strategy, discuss the outlook for municipal bonds and how advisors can take advantage of opportunities in this space.

Figure 1: Municipal bonds offer attractive tax-equivalent yield
Yield-to-worst across fixed income asset classes

What’s been driving municipal bond performance in 2023?

Sean: Just like 2022, the story of 2023 has been about the Fed. We have seen four rate hikes year-to-date, in addition to the seven hikes last year, which has driven the Fed Funds rate to a 22-year high.¹ As a result, the benchmark 10-year Treasury, which began the year at 3.88%, has continued to increase, most recently trading at 4.92%.² This increase in rates, along with lack of demand, has driven lackluster performance in the municipal sector—the broad Bloomberg Municipal Bond Index is down 1.86% year-to-date,³ compared to the taxable bond market, with the Bloomberg U.S. Aggregate Bond index down 3.04% year-to-date.

Not surprisingly, long maturity munis have largely driven the negative returns this year, given their sensitivity to rising interest rates. We’ve observed that investors have been cautious about committing money to fixed income given the volatile rate environment. As such, dampened demand for munis has led to outflows from municipal bond funds for most of this year.⁴ While markets believe the Fed is fast approaching, or has already reached, the end of its hiking cycle, the Fed has indicated rates will likely stay high for an extended period of time.

Historically, early autumn weakness in munis has given way to strong performance into year-end performance. Over the past five years, November and December have produced a combined total return of 219 basis points per year on average.⁵

How could municipal bond investors manage around the inverted yield curve?

Sean: The U.S. Treasury curve is inverted with the spread between 2- and 30-year maturities totaling negative 30 basis points. However, the comparable municipal curve remains relatively steep at plus 80 basis points.⁶ We like a barbell yield curve strategy , pairing front-end exposure with an increased but modest allocation to the 15- to 20-year part of the curve. While investors could take advantage of the historically high rates in the short end, it’s important to remember that we are seeing yields out on the longer end of the curve that we haven’t seen in close to a decade.⁷

Investors may want to lock in this “durable yield” now to reap its benefits for potentially years to come. Over the past four Fed tightening cycles, 2-year U.S. Treasury yields have retraced 30% on average during the 12 months following their peak.⁸ Particularly in the 15- to 20-year part of the curve, investors can now pick up most of the yield of the entire curve with less duration than 30-year bonds.⁹

Where are the flows going in municipal bond funds and ETFs?

Karen: Over the past five years, municipal bonds funds experienced positive flows in both mutual funds and ETFs.¹⁰ In 2022, with rising rates, investors redeemed $150 billion of municipal bond mutual funds and $30 billion was invested into municipal bond ETFs. In 2023, municipal bond ETFs grew at a rate of $5.6 billion, while $5.5 billion was redeemed out of mutual funds.¹¹

Figure 2: Annual municipal bond fund flows 2018 – 2023 (billions)

How can investors build municipal bond portfolios today with mutual funds and ETFs?

Karen: The BlackRock Bond Pyramid offers a framework to think about the different roles bonds play in the portfolio. Each municipal bond investment, whether it is an individual bond, mutual fund or ETF, can be mapped to a rung on the Bond Pyramid. Investors can then scale their positions based on their goals, risk tolerance and time horizon.

Step 1. Start with the BlackRock Bond Pyramid.

Consider what role each fund plays, and then optimize your bond mix based on your larger asset allocation.

• Income: While most municipal bonds offer income that is exempt from federal income tax, issuers with lower credit ratings can offer more income relative to their higher-rated counterparts. When investing in lower-rated bonds, maintaining issuer diversification can lead to better outcomes and reduced concentration.
• Capital Preservation: Short-maturity municipal bonds can potentially offer less volatility and preservation of purchasing power. Since the yield curve is inverted, these bonds may offer tax-exempt income above the impact of inflation, meaning a positive real yield. 
• Equity Market Diversification: For those investors looking for bonds to offer diversification compared to stocks, longer maturity or higher quality bonds typically offer lower correlations to the stock market. Broad municipal bond mutual funds and ETFs, that include longer duration securities, can serve this purpose in the portfolio. 

Step 2. Barbell each rung of your pyramid.
Consider anchoring your portfolio with low-cost bond ETFs and allocating your fee budget to flexible and alternative active strategies.

How to build your portfolios

In today’s environment, consider adding back duration with equity diversification and preserving capital.

Conclusion

Now with higher yields, municipal bonds can hold a place in the portfolio as many investors rebuild their bond allocations. 

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