US municipal bonds, also known as muni bonds or munis, are bonds issued by US states, cities or local government bodies. They can take the form of general obligation (GO) bonds, funded via tax revenues, or revenue bonds, secured by an income stream from a specific local infrastructure asset. Historically, this has meant that default rates have been low, and risk adverse investors could consider investing in munis as a way to diversify corporate bond holdings.

The majority of municipal bonds are issued in a format that exempts the holder from US federal income tax, and potentially local state taxes – a significant benefit for many US domiciled citizens and corporates. However, there is a growing section of the municipal bond market that is issued in a fully taxable format – by issuing fully taxable debt, the issuer has greater flexibility on how they can use the proceeds. Taxable municipal bonds generally trade with a higher gross yield than their tax-exempt counterparts, and this has led to an increase in demand from non-US investors.

Today, the US municipal bond market supplies around 80% of the capital needed for US infrastructure maintenance and development[1]. Currently, there are 56,248 issuers in the market; this represents almost USD4 trillion in lending[2].

From an investment perspective, US municipal bonds are seen as a high-quality asset class. Individual US states that issue infrastructure-related bonds might be major economies in their own right, with levels of growth comparable to that of sovereign countries. For example, the gross domestic product of California alone is equivalent to that of the United Kingdom[3].

[1] Source: SIFMA as at 30 June 2021.

[2] Source: SIFMA as at 30 June 2021.

[3] Source: Bureau of Economic Analysis (BEA) and International Monetary Fund as at 31 December 2020.

The left-hand graph below shows the ratings of all US municipal bonds versus global corporate bonds, with ‘Aaa’ being the highest and C the lowest. As you can see, most US municipal bonds fall within the higher-quality end of the ratings scale.

Meanwhile, the right-hand table demonstrates the relatively lower defaults among US municipal bonds in relation to global corporate bonds. It also reveals that recovery rates for municipal bonds are higher than those of senior unsecured global corporate bonds. This means investors may have a better chance of getting some of their money back if a US municipal bond defaults.

Sources: 1. Moody’s Investors Services as at 31 December 2020; 2. Source: Moody’s cumulative default rates by rating category, 1970-2020; 3. Moody’s Investors Service as at 30 September 2020, average corporate debt recovery rates for senior unsecured bonds 1970-202

In this table, we show how the performance of the US municipal bond market compares to other types of fixed-income instruments. From January 1997 to September 2021, for every 1% of growth in the US municipal bond market, you would have achieved only 0.68% had the same amount been invested in investment-grade bonds or 0.52% from US Treasuries.

Source: Bloomberg, Barclays, Merrill Lynch as at 30 September 2021. *Correlation matrix based on total returns, since 1 January 1997

We often hear the term “monetary tightening”. What this refers to is the process of raising interest rates. Central banks often do this to cool an overheating economy, as higher interest rates make borrowing more expensive. Higher interest rates can also make the interest paid out by some bonds look less appealing, as investors could potentially find higher rates elsewhere.

In the graph below, we show that despite increases in US interest rates, based on historical data, municipal bond performance (including reinvestment of income) were able to deliver positive returns. Investors may consider US municipal bonds in an adverse performance environment for fixed income.

Source: Municipal Market Data MMD, FRED, Bloomberg, firm data as at 30 June 2021. For illustrative purposes only.

Note: the bars labelled “1-5 yr”, “1-10 yr” and “3-15 yr” are representative of the returns of the “1-5 year”, “1-10 year” and “3-15 year” Bloomberg Barclays US Municipal Index respectively. The bars labelled “Muni” are representative of the Bloomberg Barclays US Municipal Index’s total returns in the corresponding years on the X-axis (i.e. 1994/1995, 1999/2000, 2004-2006 and Dec 2015 – Dec 2018). The time periods depicted in the chart are the most recent instances where the Federal Reserve tightened monetary policy, or raised interest rates (as shown by the green bar representing the magnitude of rate hikes). Similarly, the blue bars show the relative performance of several distinct municipal indices during the same time period (delivering positive returns).

Launched in 2017, the BNY Mellon US Municipal Infrastructure Debt Fund was one of the first products to invest predominately in taxable and tax-exempt infrastructure-focused US municipal bonds.

The Fund aims to provide as high a level of income as is consistent with the preservation of capital. This is not a capital guaranteed fund and there is no guarantee of the repayment of principal.

By taking a long-term approach to investing, our dedicated US municipal debt team seeks to capture opportunities in the US municipal bond market. The team invests in taxable and tax-exempt municipal infrastructure bonds, enabling it to uncover the holdings which are most likely to help us to achieve the fund’s investment objective.

We take a pragmatic, long-term approach to investing. This allows our team to identify bonds that are attractive on a risk-adjusted basis.

The USD4 trillion municipal bond market is a natural avenue for ESG investing. State and local governments regularly finance numerous long-term public projects that align well with sustainable missions led by prudent and responsible governance.

Our team of senior sector and region-specific research analysts formulate recommendations based on myriad

fundamental credit factors including traditional metrics such as balance sheet, economic/tax base, financial metrics and bond covenants. Beyond traditional metrics, our analysts consider key ESG risk and opportunity themes across a wide subset of sectors. Our proprietary Muni ESG analytical framework breaks down ESG risks into five key themes: climate change, aging US infrastructure, natural resource scarcity, demographic shifts and governance.

These risks have credit and fiscal implications for a municipality’s spending, debt, revenues, liquidity, and rainy-day

reserve profiles. Careful consideration of these factors, along with traditional fundamental credit metrics, trading

levels and ratings analysis, are key to our bond selection process.