Municipal bond yields: A renaissance of tax-exempt income

Key highlights

• Municipal bonds now feature much improved yields (especially after adjusting for taxes) because of the negative returns they experienced in the first quarter of 2022.
• These higher yields are available even as creditworthiness for municipal issuers is arguably stronger than it has been in recent years.
• The risk of price volatility persists, but a cost-averaging buying strategy can help to mitigate this risk.

What goes down must go up

Municipal bonds suffered a 6.58% loss from December 31, 2021, through July 31 of this year,¹ drawing the notice of investors accustomed to a low-volatility tax-exempt bond environment.

But in fixed income, what goes down in price must go up in yield. Nominal municipal bonds featured a yield to maturity of 2.79% as of July 31.¹ That presented attractive valuations both relative to other bond sectors and from a historical perspective. In the past ten years, muni yields have only been higher 13% of the time within daily observations. With a AAA Muni yield/Treasury ratio of 97% at 30 years, tax-exempt debt is particularly attractive in the long end of the yield curve.

Depending on an investor's state and federal income tax brackets and the particular investment, the investor's tax-equivalent municipal yield may be higher than 5%. For investors in higher-tax states like California and New York, taxable-equivalent yields of corresponding state indexes may be nearly 5.75% for CA, or higher for NY.

Municipal tax-equivalent yields are relatively attractive

(as of July 31, 2022)

Source: Bloomberg indexes, using yield-to-worst data as of July 31, 2022. The municipal tax-equivalent yield is calculated using a 40.8% tax bracket, which includes a 37.0% top federal marginal income tax rate and a 3.8% Net Investment Income Tax to fund Medicare.

Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Despite the negative returns it took to get here, higher municipal yields potentially can provide higher levels of tax-exempt income for years to come.

How the market turned

The municipal market, despite its idiosyncratic nature, is much influenced by U.S. Treasury yields. When Federal Reserve officials signaled their commitment to fighting inflation early this year, investors began pricing in some 11 to 13 quarter-point expected interest rate hikes through 2022, which upended the fixed income markets. Municipals were no exception.

A fundamentally solid market

Typically, a significant risk-off event is required to reach current yield levels, such as an economic recession. Such conditions threaten downgrades or even defaults. But in today's environment, municipal credit has been bolstered by federal fiscal stimulus provided directly both to municipalities as well as to end consumers.

State and local income tax revenues have risen at a velocity not seen in 20 years, easing near-term credit concerns. Issuers have used some of the flood of finances to build up their rainy-day funds, which can be a cushion for meeting budgets even during recessionary or otherwise difficult conditions. All of which means that credit conditions are better than they have been in years. Such measures will likely safeguard municipal bond valuations relative to other credit sectors (like U.S. corporates) in the event of a downturn.

States' rainy-day funds as a percentage of general fund expenditures

(50-state median, for fiscal years indicated)

Sources: Pew Charitable Trusts, using data from the National Association of State Budget Officers as of December 31, 2021.

National totals for state and local income taxes

(in billions)

Source: U.S. Bureau of Economic Analysis, as of June 30, 2022.

Cost averaging in reentry

These arguments for an attractive yield in a healthy market are not meant as a timing signal, since there are risks with all investments.

It is possible that the market will continue to price in more interest rate hikes and that outflows could continue. Either of these potential events could lead to further price drops (and yield increases) in the near future.

However, the bond market has already factored in an aggressive Fed rate-hiking campaign. While there is substantial uncertainty around Fed policy in 2023, longer term yields seem to be settling close to the Federal Reserve's long-run neutral rate of 2.5%. If markets calm around these levels, it could create a technical tailwind for municipal bond pricing as cash that left tax-exempt funds earlier in 2022 may return.

Investors considering a new allocation to the muni sector, or those hoping for reentry after fleeing earlier this year, might consider a cost-averaging strategy. This would help diversify the risk of coming in too early or too late.

A better buffer

With yields as high as they are, municipal bond funds offer a buffer against yields rising even further. A muni bond fund with a yield of 2.79% and a duration of 6 years, would still provide a positive return for the next 12 months even if yields were to rise another 40 basis points across the curve.

Duration is the weighted average time for an investor to receive coupon interest and principal payments that would potentially allow the investor to recoup the bond's price from its cash flows.

1 Figures as indicated by the Bloomberg Municipal Bond Index.

2 As reported in each fund’s most recent prospectus. A fund's current expense ratio may be higher or lower than the figure shown.

3 Investor Shares available only. There is no minimum investment required for advised clients.

Notes:

• For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
• Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
• Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
• Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
• Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
• Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.