Exploring the potential of muni bonds

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What appeal could US municipal bonds hold for European investors? Here, Jeffrey Burger, portfolio manager municipal bonds at Insight Investment1, 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 by US states and local governments to be “perpetual ongoing concerns and natural monopolies”- which could 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 could municipal bonds offer?

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
  • Heterogenous security-specific exposure— with 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, historically have outperformed other fixed asset classes while under interest-rate pressures. “When interest rates rise, there’s more tax advantage for US investors owning municipal bonds. Even non-US taxpayers benefit from this fact as the bonds may become more valuable due to the tax-free nature desired from the US investor” says Burger. “And if US taxes go up, there’ll likely be more demand for this asset class.”

From a thematic perspective,” Burger adds, “municipal bonds could provide investors with 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 may subsidise 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 trillion2 in size, with more than 55,000 issuers3. “With that many issuers,” Burger says, “it can lead to inefficiency. And from an inefficiency perspective, from where investors sit, that means opportunity.”

There also is a lack of institutional penetration in the market. This sector is still dominated by US investors, with 73%4 of this market comprised of retail investors, who receive favourable 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 is that some funds are tax-free (which offer a lower yield) and others are taxable (which owing to a tax-code change means they can in some cases offer higher yield).

What that change means to the overseas investor,” Burger says, “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.”

Burger continues: “What we have observed recently is the growth of interest we’re seeing from overseas investors, in large part because they can get higher yield, they’re becoming aware of inefficiencies and opportunities in this market, and they’re recognising the high credit quality of this asset class.”

1 Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Managers Limited (BNYMFM), BNY Mellon FundManagement (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and servicesentered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.
2 Municipal Securities Rulemaking Board. Muni facts. As at 31 December 2020.
3 Ibid
4 SIFMA as at 31 March 2020.

759182 Exp: 5 June 2022

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