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. In 2021, through May 31, investors had allocated $50.0 billion to municipal bond funds, which is almost as much as they invested through all of 2020, according to Morningstar.
Some of the recent interest in municipal bonds has been driven by President Biden’s efforts to push a tax increase through Congress for corporations and the most affluent Americans this year. However, if those tax increases do not get enacted – or if they are smaller than originally proposed – municipal bond prices could come under pressure.
Demand had been high in the international market where bond yields have been extremely low – including negative yields for some government issues in Europe and Japan. However, the appetite for municipal bonds in the international market has cooled off recently.
Despite the COVID-19 pandemic, credit quality in the muni market has actually improved recently for many issuers. State and local governments have fared better than expected thanks to higher tax receipts, and Congressional stimulus aid has bolstered the balance sheets of local governments and many types of revenue bond issuers.
Assessing bond issues
Our primary consideration in evaluating a bond issue remains essentially the same as always – whether or not an entity will be willing and 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.
However, there are subtle differences in our analysis when evaluating a general obligation bond versus a revenue bond.
Each type has its place in our portfolio, but 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, airports, and educational and health facilities. Revenue bonds generally pay a higher yield than general obligation bonds, which increases the income we are able to offer shareholders.
Finally, ESG – environmental, social and (corporate) governance – has also become a more prevalent factor in assessing potential holdings.
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:
- Inflation. While there is some concern over the possibility of an economic downturn, the risk of rising inflation is a bigger concern in the current market.
- 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. However, President Biden’s plan to raise income taxes for corporations and the wealthy has already prompted growing interest in municipal bonds.
- Financial weakness. As funding dries up from the CARES Act and other federal stimulus programs, there is some concern that some entities may face credit weaknesses – particularly those that may be using the funding to develop or operate new programs.
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 – Thrivent Municipal Bond Fund (TMBIX) and Thrivent High Income Municipal Bond Fund (THMBX).
The primary difference between the two is that Thrivent High Income Municipal Bond Fund pursues higher total return by assuming more credit and duration risk than Thrivent Municipal Bond Fund.
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.*
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 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. 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.
