Slowing Economy: 3 Reasons Municipal Bonds Make Sense

Most investors seek stable and secure investment options in the face of economic decline marked by intense market volatility and wavering consumer confidence. With their strong credit ratings, favorable credit conditions, and historically positive performance during recessions, municipal bonds emerge as an attractive choice. Here are 3 reasons municipal bonds may be a good investment if we face an economic slowdown.

Reason #1: Higher Credit Ratings for Municipal Bonds

Municipal bonds tend to have higher credit ratings compared to corporate bonds. Approximately 70% of bonds in the Bloomberg Municipal Bond Index hold the two highest credit rating categories, contrasting with only 8% in the Bloomberg Corporate Bond Index. Factors contributing to these robust ratings include the absence of competition for many muni issuers, durable revenue sources such as taxes, and the rarity of defaults, even during recessionary periods. In the 2007-2009 financial crisis, only 12 rated muni issuers defaulted, in contrast to 414 corporate bond issuers of similar credit quality.

Reason #2: Improved Municipal Bond Credit Conditions

Most state and local governments have benefited from strong fiscal conditions due to substantial federal government support during the pandemic and surging tax revenues. Rainy-day funds, intended to address unexpected deficits, have reached near-record levels. Even the lowest-rated state in the muni market, Illinois, has significantly increased its rainy-day fund balance, providing added financial stability. Tax revenues typically do not decline until the later stages of a recession, allowing states time to adjust expenses and recover quickly.

Total Balances (in millions of dollars) 50-State Median

Source: The Pew Charitable Trusts. Gray bars represent U.S. recessionary periods. Data is reported by each state for its fiscal year, which ends June 30 in all but four states: New York (March 31), Texas (Aug. 31), and Alabama and Michigan (both Sept. 30). Past performance is no guarantee of future results. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.

Reason #3: Positive Municipal Bond Historical Performance Post Recession

Investment grade municipal bonds have shown positive total returns in the 12 months following the start of a recession in 5 out of the past five, showing they have been resilient during economic downturns. Only during the 2007-2009 recession, which saw a global credit crisis, did munis post a negative return. Performance during recessions is influenced by various market dynamics, with each downturn having unique characteristics. Historical examples, such as the 1981 recession driven by aggressive interest rate hikes and the 1990 and 2001 recessions characterized by yields moving lower, demonstrate the potential for positive muni returns during economic slowdowns. It is important to consider the current market conditions, as muni yields are presently at their highest levels in over a decade.

Bloomberg Municipal Bond Index 12-Month Total Return

Source: Bloomberg as of July 10, 2023. Past performance is no guarantee of future results. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.

Regardless of the economy's direction, municipal bonds are appealing, given their tax-advantaged income. Investors should focus on highly rated issuers known for their resilience during economic declines, which can provide insulation for their bond portfolios if a recession occurs. While past performance can offer insights, it is crucial to recognize that each recession is distinct and influenced by different factors. However, the combination of strong credit ratings, favorable credit conditions, and historically positive performance make municipal bonds a compelling choice for investors amid a slowing economy.

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