Municipal bond funds have traditionally enjoyed a steady demand among high income individuals because of their potential tax-free income and diversification.

But their popularity has escalated recently, with $95.6 billion in net inflows in 2019, according to Morningstar. That is more than the net flows of the previous four years combined.

That included $19.3 billion of inflows for high yield municipal bonds. A total of $16.6 billion in high yield municipal bonds were issued in 2019, which represents a 31% increase over the previous year. The rising demand for municipal bonds and funds has been fueled by a variety of factors:

• Tax changes. The 2017 federal tax act limited the amount of state and local taxes that residents could deduct from their adjusted gross income to just $10,000. That change has prompted affluent residents in high tax states, such as New York, New Jersey and California, to try to offset the bump in their tax burden by increasing their holdings in tax-free bonds.

• Favorable yields. In this low-interest environment, tax-free municipal bond yields have often compared favorably in terms of after-tax return versus taxable bonds for high income earners.

• International demand. With extremely low bond yields in the international market – including negative yields for some government issues in Europe and Japan – foreign investors have turned to the U.S. bond market to gain a greater return on their fixed income investments.
  

A changing market

As demand has risen in recent years, government entities have ramped up the supply of municipal bonds to meet that demand. But because of some notable recent defaults, general obligation bonds (GOBs) don’t always carry the same level of confidence they once did.  While defaults on GOBs are still very rare, we have seen some well-publicized defaults in Detroit and Puerto Rico, as well as some other smaller issues.

Our primary consideration in evaluating a bond issue remains essentially the same as always – whether or not an entity will be able to pay the required debt service in full and on time, and whether the yield we receive compensates us for the risk we take. If the entity appears to be solid financially, their GOB issues would typically earn a premium valuation.

However, there are some subtle differences in our analysis. While we’ve always evaluated bond issues based on an entity’s ability to pay, now we also have to take into consideration its willingness to pay. We’ve also placed a greater emphasis on finding bonds that are backed by dedicated taxes or revenues, such as water and sewer projects, toll roads and airports.

One other factor industry analysts now assess is the effect that climate change could have on a particular entity – particularly heat stress, hurricanes, and earthquakes. If we believe an entity issuing bonds is unprepared to deal with those types of events, we would expect a higher yield on those bonds to compensate for the risk.

The case for caution

While economic growth has been solid for the past decade, there are several factors that could have a detrimental impact on the municipal bond market:

• Economic downturn. If the economy begins to decline, that could lead to credit deterioration and dampen the appetite for municipal bonds among affluent individuals.

• Change in relative value. If yields offered by municipal bonds are no longer as attractive relative to taxable bonds, that could also reduce investor interest in municipal bonds.

• Change in tax policy. A change in tax laws could also affect investor demand. For instance, if the provision limiting the deduction for state and local taxes were rescinded, that could reduce demand for tax-free bonds.

High yield versus high quality

Municipal bond investors tend to be high-net worth individuals, and their municipal bond investments tend to represent the conservative portion of their portfolio. However, in order to serve the needs of investors who are focused on capital preservation and those who lean toward total return, we offer two municipal bond funds – the Thrivent Municipal Bond Fund  (TMBIX) and the Thrivent High Income Municipal Bond Fund  (THMBX).

The primary difference between the two is that the Thrivent High Income Municipal Bond Fund pursues higher total return by assuming more credit and duration risk than the Thrivent Municipal Bond Fund.

The Thrivent High Income Municipal Bond Fund invests in higher yielding, lower rated bonds, with a target allocation of 30% in A-rated or higher bonds, 55% in BBB and BB rated bonds, and 15% in bonds rated below BB.

The Thrivent Municipal Bond Fund seeks a high level of current income exempt from federal income taxes, consistent with capital preservation. It generally invests in higher rated bonds, with about 80% of assets typically invested in bonds rated “A” or higher and about 20% of assets in BBB and below rated bonds.

With both funds, we try to maintain broad diversification by sector and geography, with about 55% to 60% of our assets spread across the top 10 states.

The sector allocation for the Thrivent Municipal Bond Fund includes major investments in transportation, education, health care and utilities, as well as special tax revenue bonds, pre-refunded bonds and local and state government bonds. The Thrivent High Income Municipal Bond Fund also has significant investments in many of the same areas, but with less investment in pre-refunded bonds and more investment in industrial revenue bonds.

Janet Grangaard has been a portfolio manager for Thrivent Financial since 1994. She serves as the portfolio manager for both the Thrivent Municipal Bond and the Thrivent High Income Municipal Bond Fund.