Vanguard expects municipal bond ‘renaissance’ as investors should ‘salivate’ at higher yields

Muni bonds offered “yields barely over 1%” at the start of 2022, compared with yields now exceeding 3% before adjusting for tax benefits, according to the report. With tax-equivalent yields of 6% — “or meaningfully higher for residents in high-tax states who invest in corresponding state funds” — munis offer “great value compared with other fixed income sectors and potentially even equities—especially with the odds of a recession increasing,” said Vanguard.

Muni bonds remain “strong” from a credit perspective, with attractive spreads over comparable U.S. Treasurys compared with corporate debt, according to the report. Spreads widened last year even as municipal balance sheets were “stronger than they’ve been in two decades and rainy day funds at all-time highs, leaving states well prepared to weather an economic slowdown or contraction,” said Vanguard.

The chart below tracks spread widening for corporate and municipal debt rated BBB, the lowest rung of investment-grade, in 2022. It represents the change in yields above Treasurys with similar durations, showing that BBB-rated munis were offering investors more spread by year-end.

“Intermediate- and long-term municipal bonds should provide both higher levels of tax-exempt income and the diversification potential that investors traditionally covet in their fixed income allocations,” said Vanguard. “With tax-loss harvesting opportunities ending, we expect that high-earning investors will be motivated to increase their tax-exempt holdings over time.”

Vanguard’s actively-managed Long-Term Tax-Exempt fund
VWLUX,
+0.37%
has gained 2.8% so far this year through Tuesday, while its Intermediate-term Tax-Exempt fund
VWIUX,
+0.22%
is up 2%, according to FactSet data.

“Higher yields not only mean greater income, but also greater portfolio stability if a deeper recession transpires,” said Vanguard.

As for municipal bonds tied to specific states, the Vanguard New York Long-Term Tax-Exempt fund
VNYUX,
+0.37%
has risen 3.1% this month through Tuesday, while the Vanguard New Jersey Long-Term Tax-Exempt fund
VNJUX,
+0.26%
has returned 2.9%, FactSet data show. The Vanguard California Long-Term Tax-Exempt fund
VCLAX,
+0.26%
gained 2.8% over the same period, while the Vanguard Massachusetts Tax-Exempt fund
VMATX,
+0.39%
was up 2.9%.

“We believe the municipal bond market has already broadly priced in a recession,” said Vanguard. “Unlike prior economic contractions, this time it will be downgrade activity that catches up to current spread pricing—not the other way around.”