Municipal bonds (Munis) are an often overlooked but integral segment of the US bond market. Most investors are drawn to the asset class due to its popular tax-exempt status, which can be quite attractive for individuals seeking tax-free income. Other investors appreciate the relatively low default rates, stable returns, and diversification benefits from the lower correlation to other fixed income asset classes.
Today, we provide a brief overview of the municipal bond market and highlight several unique market dynamics that, in our opinion, create a rich opportunity to add value to investors’ portfolios. Over the coming weeks, we will dive into specific municipal bond market characteristics in more detail.
Overview:
In total, the municipal bond market is approximately $4 Trillion in size, making up about 7.50% of the entire US Fixed Income market. The size of the market has remained stable over the years. These bonds, which are issued by state and local governments to fund various projects such as schools, roads, hospitals, and utilities, offer investors an attractive way to earn tax-exempt income while supporting their local communities. The market is sufficiently large and diverse, with many different types of bonds and issuers.
The market is divided into two main segments: the primary market and the secondary market. In the primary market, new bond issues are sold to investors through underwriters. Typically, the underwriters buy the bonds from the issuer and sell the bonds to investors at a mark-up. In the secondary market, investors buy and sell previously issued bonds among themselves either through offerings or bid-wanted situations.
There are several structures of municipal bonds including general obligation bonds (unlimited or limited), revenue bonds and certificates of participation. General Obligation bonds (GOs) are typically backed by the full faith and credit of the issuer, while revenue bonds are backed by the revenues generated from the project or facility.
Munis are popular with individual investors because they offer tax benefits. The interest paid on most municipal bonds is exempt from federal income tax, and in some cases, state, and local income tax as well. This makes them particularly attractive to investors in higher income tax brackets.
In summary, the municipal bond market is an important source of financing for state and local governments and a key investment option for many individual investors’ portfolios.
Market Dynamics:
1. Retail Dominance: Individual investors as a group are the largest segment of the municipal bond market. This is a unique feature compared to other fixed income asset classes that can influence the yield curve, spreads, liquidity, and volatility in the market. Sophisticated investors can seek to capitalize on this unique market dynamic.
2. Tax Advantages (and Considerations): The primary attraction to municipal bonds is the tax-exempt income. The yield advantage on an after-tax basis creates value for taxable portfolios, particularly notable for high-net-worth investors. Furthermore, after considering the relatively low credit risk, the after-tax income potential can be even more appealing. It is worth noting that there are some unique tax situations that may create unforeseen tax liabilities.
3. Credit Risk (Default & Recovery Rates): Munis have historically had a lower default rate with higher recovery rates compared to corporate bonds of similar credit quality. Nevertheless, Muni defaults do occur but are typically idiosyncratic.
4. Over-the-Counter Trading & Pricing: Munis trade over the counter (OTC), meaning that trading activity is conducted through a network of broker-dealers as opposed to a centralized exchange. The illiquid, diverse, and OTC nature of the Muni market makes valuations a challenging endeavor but can create opportunities for experienced market traders that have knowledge of valuation and market sentiment.
5. Financial Reporting & Disclosures: Municipalities are primarily subject to local city and state regulations with diverse financial reporting requirements. This lack of uniform transparency opens the door for investors willing to do more in-depth research on specific credits to find value in underpriced and misunderstood municipal issuers.
6. How to invest? Investors primarily obtain exposure to Muni bonds through mutual funds, ETFs, separately managed accounts (SMAs), and brokerage accounts. Each of the options has pros and cons and therefore it depends on an investor’s time horizon, size, and need for liquidity to determine which is ideal.
Sources:
Securities Industry and Financial Markets Association (SIFMA)
Disclosures:
This content has been prepared for informational purposes only and should not be considered as investment advice. We recommend all investors to consult with a financial and/or tax advisor before taking investment decisions.
Investing in bonds exposes the investor to the risk of loss of principal. Lower and non-rated securities are more volatile and less liquid than investment grade bonds.
Please visit our website for a complete list of disclosures and risks: www.maustininvestments.com.