Prime Time for Diversifying with Municipal Bonds, According to Capital Group

Municipal bonds, though not common in defined contribution retirement plans, are a good diversifying investment in the current market environment due to strong fundamentals, resistance to recessionary influences and strong income that can help cushion price volatility, according to a recent report from Capital Group.

As the economy potentially enters a decline and the risk of recession looms, municipal bonds can be an apt solution, wrote two experts from Capital Group’s fixed income division, Greg Ortman, an investment director, and Karl Zeile, a portfolio manager, in a report released April 6. 

“We can’t predict the depth or length of a recession, but historically, munis have shown strong recovery after recessionary periods,” Zeile said in the report.

Defaults have been rare for municipals, according to separate analysis from Moody’s Investors Service. Since 2012, the five-year U.S. municipal default rate is, on average, 0.1%. Meanwhile, the five-year global corporate default rate has averaged 7.2%.

While municipal bonds may be a good investment option, generally, they are not common in defined contribution retirement plans and would be better used to diversify outside of a workplace retirement plan as guided by a financial adviser, according to experts.

DC plan investment data as considered by Morningstar Investment Management LLC shows minimal exposure to municipal bonds, according to Nathan Voris, head of channel strategy for retirement and workplace solutions at Morningstar.

Voris says an actively managed core bond fund may have “very small exposure” to municipal bonds in the range of less than 3%, but otherwise the tax-free income from the bond does not make it attractive for a DC plan that would be taxed at distribution. Voris did note that, if a participant is working with an adviser who felt it appropriate to add municipal bonds, they can often be added through the self-service brokerage window.

“If someone is working with an adviser, and that adviser sees a municipal bond as a diversifier for that individual, it certainly is available in the window across many providers,” he says. “It really depends on the advice you’re getting from your adviser—the value of that brokerage window is that those options are available.”

Paying the Bills

Supported by essential services that typically have high collection rates, muni-related services are less sensitive to economic indicators, the Capital Group team wrote. They are typically the “last skipped bill.”

“When recession knocks at the door with a car payment, credit card and a water bill due, everyone wants the ability to take a shower,” Ortman said in the report. “People might not dine out at a restaurant, but they will open their wallets for water, electricity and gas to avoid shut-off.”

“Trash isn’t trash,” Ortman said. “For-profit companies, such as those in waste management, hold contracts with local city governments, and they issue muni debt to help finance operations. Trash pickup has been very recession-resistant, and it’s typically a much higher priority than a store credit card.”

However, it should be noted that not all muni services are infallible. Transportation agencies, for example, saw a large drop in ridership, experiencing more volatility than in a traditional market, during the height of the COVID-19 pandemic, according to Capital Group.

Strong Fundamentals

Munis have also been able to meet return debt obligation, making them a more stable option for investment, according to Capital Group. As part of pandemic relief programs, the federal government disbursed billions of dollars to state, local and tribal governments.

“States [in aggregate] saw two consecutive years of double-digit percentage revenue growth and collections far exceeding budget forecasts in fiscal 2021 and fiscal 2022,” according to the National Association of State Budget Officers.

The enlargement of state funds benefits general bond obligations, a category of munis paid back by property, income and sales taxes. Revenue bonds, another portion of the municipal market, are paid back by related revenue streams.

Issuers borrow at very low rates for revenue bonds and are thus able to finance capital expenditures and infrastructure at similarly low rates, Capital Group noted. Regular refinancing is also not necessary for munis, which have fixed-rate, decades-long debt issuance when the projects come to market.

One other factor in munis’ favor is that, on these projects, inflation leads to rising revenues, with toll roads one such example.

“When the toll price increases, greater revenues provide an incremental cushion against a fixed debt service cost,” Zeile said in the report. “Issuers with growing revenues and low fixed costs can create attractive opportunities for muni bond managers.”