By Michael Cohick, Head of Product Management
In the face of the economic downturn characterized by high market volatility and fluctuating consumer confidence, most investors are looking for stable and safe investment opportunities. Municipal bonds are proving to be an attractive choice due to their good credit ratings, favorable credit conditions and historically positive performance during recessions. Here are three reasons why municipal bonds could be a good investment when we face an economic slowdown.
Reason #1: Higher credit ratings for municipal bonds
Municipal bonds tend to have higher credit quality than corporate bonds. About 70% of the bonds in the Bloomberg Municipal Bond Index are in the top two rating categories, compared to just 8% in the Bloomberg Corporate Bond Index. Factors contributing to these robust ratings include the lack of competition for many municipal issuers, enduring sources of revenue such as taxes, and the rarity of defaults, even during recessionary periods. In the 2007–2009 financial crisis Only 12 rated municipal bond issuers defaulted, as opposed to 414 corporate bond issuers of similar credit ratings.
Reason #2: Improved credit conditions for municipal bonds
Most state and local governments have benefited from strong fiscal conditions due to significant federal government support during the pandemic and rising tax revenues. “Rainy Day Funds” earmarked to deal with unexpected deficits have reached near record levels. Even Illinois, the state with the lowest credit rating in the municipal market, has significantly increased its fund holdings on bad days, providing additional financial stability. Tax revenues typically don’t fall until the later stages of a recession, giving states time to adjust spending and recover quickly.
Total Balances (in millions of dollars) 50-state median
Source: The Pew Charitable Trusts. Gray bars represent recessionary periods in the US. Each state reports data for its fiscal year ending June 30 in all but four states: New York (March 31), Texas (August 31), and Alabama and Michigan (both 30. September). Past performance is no guarantee of future results. Index performance does not reflect fund performance. It is not possible to invest directly in an index.
Reason #3: Positive historical post-recession municipal bond performance
Investment-grade municipal bonds have posted positive total returns in five of the last five months in the 12 months since the onset of a recession, showing that they have proven resilient in economic downturns. Only during the 2007-2009 recession, which led to a global credit crunch, did municipalities post a negative return. Performance during a recession is affected by various market dynamics, with each downturn having unique characteristics. Historical examples such as the 1981 recession, which was triggered by aggressive interest rate hikes, and the 1990 and 2001 recessions, which were characterized by declining yields, demonstrate the potential for positive municipal returns during an economic downturn. It is important to consider current market conditions as municipal government bond yields are now 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 not a guarantee of future results. Index performance does not reflect fund performance. It is not possible to invest directly in an index.
Irrespective of the economic development, municipal bonds are attractive because of their tax-deferred income. Investors should focus on highly rated issuers that are known for their resilience in economic downturns and the ability to protect their bond portfolios in the event of a recession. While past performance can be informative, it’s important to recognize that every recession is different and influenced by different factors. However, the combination of good credit ratings, favorable credit conditions and historically positive performance makes municipal bonds a compelling choice for investors amid a slowing economy.
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Originally published July 14, 2023.
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