The growing appeal of municipal bonds

By Danny Sarnowski, Portfolio Specialist, Wells Fargo Asset Management Global Fixed Income

Key Points

  • Investor demand for tax-exempt income is up in 2019, while new supply of municipal bonds has been modest.
  • Yet the new supply of municipal bonds in 2019 is lagging the record of recent years.
  • How should investors seeking tax-free income consider their options in this mismatched market?

Tax-filing season in April 2019 was a reality check for many Americans. For the first time since the tax bill passed in late 2017, many became aware of restrictions on the ability to claim state and local tax deductions. This change, coupled with modifications made to tax withholding tables, may have left some feeling more significantly pinched by taxes this year. In that environment, municipal bonds tend to become more appealing.

This tax “surprise” has led to an increase in demand for the tax-exempt income offered by municipal bonds. Inflows into municipal bond mutual funds have been on a record-setting pace in 2019. Through May alone, dollars invested in municipal bonds already exceeded the full-year total of any year since 2012.

Supply fails to keep up with demand

Despite the surge in demand, new issuance of municipal bonds has been subdued. It is estimated that $380 billion in new municipal bond supply will be issued over the course of the year. If the flow of new issuance continues at the current pace, however, supply would come in at the lowest level in seven years (shown as “full year run rate” in chart below). 

The impact on the bond market

This mismatch between demand and supply has pushed up municipal bond prices and helped municipal bonds outperform U.S. Treasuries on a total return basis so far in 2019. For existing holders of municipal bonds, this has been good news as many have seen their investment balances grow. For investors looking to invest additional dollars into the municipal bond market, however, this means that prices may be inflated, and values can be difficult to find. Growing demand for tax exempt income has pushed prices higher across the municipal credit spectrum. In fact, lower-rated bonds are outperforming higher-rated securities so far this year. This means that the potential to earn extra compensation by taking on additional credit risk has been reduced for those putting new investment dollars to work in 2019. Where does that leave investors interested in tax exempt income?

Markets make frequent adjustments

Although municipal bonds appear to be expensively priced relative to U.S. Treasuries, these prices can fluctuate throughout the market cycle. There may be times when municipal bonds are more attractive. And while price is an important consideration, the tax-exempt income stream provided by municipal bonds has typically made up the majority of investors’ total return.

In addition, municipal bonds tend to experience less volatility and lower default rates than other sectors of the fixed income market, making them an attractive addition to long-term investment portfolios. The main question for investors interested in tax-exempt income is not how to “time the market,” but how to benefit from “time in the market.”

Find a strategy that fits

While the $3.8 trillion municipal bond market remains highly rated with an average index rating of AA-, it is important for investors to understand the risks that may be lurk beneath the surface. We, therefore, encourage you to understand the level of diligence that is conducted at the portfolio level when it comes to selecting bonds from reliable issuers. Over the long term, municipal bonds can be expected to offer investors the benefits of diversification while helping to moderate portfolio volatility.

It makes sense to sit down with your investment advisor to review your specific tax situation, income needs, risk tolerance, and overall investment portfolio. With that information in hand, you are ready to consider whether an investment in municipal bonds is appropriate for your circumstances.