Municipal bonds have long been seen as a refuge within the bond market. In spite of everything, their credit quality and repayment are driven by the state’s and the local government’s ability to boost taxes and/or support from the underwritten projects. This money flow pays investors and provides the regular returns of muni bonds.
And it looks like municipal bond investors have something to cheer about heading into next 12 months.
State tax revenues are set to extend, while rainy day funds remain plump. At the identical time, budget and spending cuts even within the worst-off states have less money flow risks for a lot of municipalities. For investors, it’s just one other sign that munis are a top bond variety for his or her portfolios.
Taxes, Taxes, Taxes
Municipal bonds are issued by state and native governments to fund their operations, launch special projects, and supply their residents with various programs. To pay for those bonds, it’s often taxes–payroll, sales, and property–that help pay the interest and repay debt. That is where some problems have emerged over the past 12 months.
Tax revenues have been mixed at best.
The Federal Reserve’s higher rate of interest environment was designed to slow the economy. And it did slow the economy. A wide range of growth metrics have slipped. This has included incomes, property values, and consumer/business spending.
That’s a difficulty for states and native governments. They simply have brought in less money within the last two years or so.
After post-pandemic surges, 2023 state revenues were estimated to say no by 1.1%. While the National Association of State Budget Officers (NASBO) tallies for this 12 months haven’t been accomplished with roughly three months left to the 12 months, we are able to safely say tax revenues shall be barely above or flat for the 12 months.
For investors, this presents an issue. Tax declines reduce the sum of money collected that may be used to pay back bonds and interest.
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A Higher Money Flow Situation
Nonetheless, 2025 could prove a a lot better 12 months for municipalities and their bondholders. That’s the gist in response to a latest missive from asset manager Northern Trust. It seems the state’s taxes and their rainy day funds are set to extend, providing loads of safety for his or her budgets and bonds.
For starters, state balance sheets are stuffed with money.
An influx of pandemic-issued money has helped many states grow their rainy-day balances to levels not seen before. In keeping with Northern Trust, total ‘rainy day fund’ reserve balances have grown to $136 billion by the top of fiscal 2023. That is up from just $77 billion in 2020 and $135 billion in 2022. And while a $1 billion year-over-year increase may not seem impressive, remember, last 12 months saw declining tax revenues. All in all, median rainy day reserves have now increased to over 13% of annual budgets, a level not seen in over 15 years. Those balances jump to 23% of annual budgets when including other funds within the states’ coffers.
Speaking of those budgets, states have been proactive in reducing spending amid lower tax receipts. Evaluation by the Pew Charitable Trust shows that states’ expected general fund spending will decline by 6% for fiscal 2025. That drop in spending is the same as the cuts experienced throughout the Great Recession/Global Financial Crisis. The cuts have come from quite a lot of states. For instance, California reduced one-time spending to reallocate resources to core services, while Arizona cut higher education spending to shut deficits.
Finally, the sorts of taxes many states are beginning to collect have modified. Income taxes—which were often the foremost income—have given strategy to other tax collections including consumption and sales taxes. The legalization of cannabis has provided a tailwind for a lot of states, while income tax cuts coupled with rising sales tax increases have provided more revenues and altered revenue makeup.
As you’ll be able to see, sales tax now provides greater than 46.6% of the state’s annual tax haul.
Source: Northern Trust
The result in response to Northern Trust is more states have higher resilience to shocks and budget issues. That’s great news for municipal bondholders.
A Big Win For Munis
The massive rainy-day funds, changes to tax collection, and lower spending are all great news for municipal bonds and their investors. Munis are already known for his or her top credit quality and now that quality has been enhanced.
This can be a particularly strong win when you concentrate on munis are their high after-tax yields. Today, you’ll be able to still buy munis with after-tax yields that exceed corporate bonds at 6.3%. That’s a giant win considering the sunsetting of the Tax Act and the incontrovertible fact that bond interest is taxed as peculiar income. That may be as high as 40% for some investors.
With munis, investors can recuperate credit quality than corporate bonds which are only strengthened and have a juicy after-tax yield.
With that, adding a dose of municipal bonds heading into the brand new 12 months makes a ton of sense. ETFs—whether energetic or passive—are the proper strategy to use them in a portfolio. Low costs and board mandates allow investors to construct a large swath of bonds with one ticker. Passive options offer just a little little bit of every part. Going energetic could provide higher returns as managers can give attention to values or states with higher resilience than others. There’s loads of evidence that energetic management in munis can lead to higher returns.
Municipal Bond ETFs
These funds were chosen based on their exposure to municipal bonds at a low price. They’re sorted by their YTD total return, which ranges from -0.5% to 0.9%. They’ve expense ratios between 0.05% to 0.65% and assets under management between $1.2B to $37B. They’re currently yielding between 1.9% and three.7%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| FMB | First Trust Managed Municipal ETF | $1.9B | 0.9% | 3.1% | 0.65% | ETF | Yes |
| MUNI | PIMCO Intermediate Municipal Bond Lively ETF | $1.47B | 0.5% | 3.7% | 0.35% | ETF | Yes |
| SUB | iShares Short-Term National Muni Bond ETF | $8.7B | 0.0% | 2.2% | 0.07% | ETF | No |
| VTEB | Vanguard Tax-Exempt Bond ETF | $34B | 0.0% | 3.1% | 0.05% | ETF | No |
| DFNM | Dimensional National Municipal Bond ETF | $1.23B | -0.1% | 3.1% | 0.19% | ETF | Yes |
| MUB | iShares National Muni Bond ETF | $36.8B | -0.2% | 3.1% | 0.05% | ETF | No |
| SHM | SPDR Nuveen Bloomberg Short Term Municipal Bond ETF | $3.9B | -0.5% | 1.9% | 0.20% | ETF | No |
All in all, states proceed to strengthen their financial positions with budget cuts, high revenues, and fat rainy-day funds. That is all wonderful news for muni credit quality. It’s that quality and money flows that make these bonds strong. Now, they’re getting even higher than within the last couple of years.
Bottom Line
After a number of years of mixed revenue collection, states are back within the swing of it. Taxes are expected to rise, while spending is projected to be way down. Adding in large rainy-day funds and munis is usually a top high-yielding bond for fixed income investors.