These tax-free bonds could see stellar returns once the Fed starts cutting rates

Published Thu, Mar 7 20242:27 PM EST

The central bank isn't showing its hand as far as when rate cuts may begin, but municipal bonds could see a pop in returns once the Federal Reserve does start easing up on policy. This week, Fed Chair Jerome Powell testified before Congress that he would need to "see a little bit more data" before the central bank takes its foot off the brakes. Such a move would bode well for fixed income, including municipal bonds. Yields and prices have an inverse relationship – and lower rates could result in price appreciation. Recent data from Columbia Threadneedle Investments and Bloomberg, shows that muni bonds can see a jump in cumulative tax-equivalent returns once the Fed begins cutting rates. The analysis used data from June 1995 to December 2023. In the three months before the first rate reduction, those returns come in at 3%. In the six months after, they rise to 4.49% –and then they hit 7.54% one year following the cut. You don't have to wait until the Fed acts to start before dipping a toe into muni bonds, which high net worth investors love because they spin out tax-free income on a federal basis – and residents of a given state who buy munis issued there may be eligible for income free of state taxes as well. When taking into account the tax savings, muni bond investors don't have to take that much risk to capture attractive yields. With a tax-free yield of 3.5%, an investor in the 32% tax bracket will have to find a taxable bond yielding 5.15% in order to match that income, according to New York Life Investments . "Even in the pause environment, the market will start moving ahead of any cuts," said Catherine Stienstra, head of municipal investments at Columbia Threadneedle, referring to the period before the Fed acts. "Primarily, tax-exempt yields are so attractive now and they remain above their long-term averages following on the heels of low rates forever." Rising flows and higher yields Investors have been pouring money into muni bond funds lately. The Vanguard Tax-Exempt Bond ETF (VTEB) has drawn $384.5 million in flows in 2024, of which $250.8 million made its way into the fund over the past week, according to FactSet. BlackRock's iShares National Muni Bond ETF (MUB) , meanwhile, has seen an exodus of more than $1 billion in flows this year, but it experienced inflows of $150.9 million in the past week. On the individual issue front, investors have sought additional yield by taking a step down in credit quality. "People are scrambling for additional yield, and there's very strong demand for single-A, triple-B and even in the high yield space," said Duane McAllister, co-lead of the municipal sector and senior portfolio manager at Baird Asset Management. Indeed, in February, lower-rated issues beat their higher quality counterparts, according to Bloomberg data compiled by Baird. AAA-rated munis posted a total return of 0.03% in February, compared to 0.27% for A-rated issues and 0.37% for BBB, the firm found. The high yield space was the top performer, with a total return of 0.79% in February. Among financial advisors and strategists, the suggestion has been for investors to consider adding exposure to bonds with greater duration – that is, longer-dated issues that have greater price sensitivity toward changes in interest rates. Short-dated instruments, including cash, have too much reinvestment risk, meaning once they mature in a falling-rate environment, investors will have a hard time finding competitive yields. "You're renting returns when you sit in cash, versus owning when you start moving out," said Stienstra. "Intermediate-term bonds are attractive, and you can go out further along the curve and lock in yields."