Can Municipal Bonds Protect Against Inflation and Recession?

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The upcoming recession is expected to have a significant impact on the muni bonds market. There are a variety of factors that affect the prices of muni bonds, such as inflation and credit spreads. To help you decide whether muni bonds are a good hedge for the coming recession, here is a look at how much inflation will be forecasted and the credit spreads for the Bloomberg Taxable Municipal Index.

Ratings drift for municipal bonds in past recessions

Municipal bonds have been relatively stable in past recessions. That’s because the credit quality of munis is relatively high. However, downgrades are common during times of economic decline.

Credit quality has also been stable in the tax-exempt bond market. Municipal bonds have historically performed better than the corporate bond market. The higher the relative yield, the more risk investors have to accept. This makes the tax-exempt market more attractive, as it enables investors to take advantage of tax-free income.

A downgrade in a bond has only a limited effect on a larger portfolio. In addition, most municipal bonds are rated ‘A’ or higher. These factors contribute to lower default rates in the muni market.

Historically, first-time defaults are extremely rare. However, as the economy worsens, this trend may change.

During recessions, a municipality’s revenue sources may be affected by adverse conditions, which could decrease its ability to pay principal. In this case, the issuer can reduce spending or use its reserves to make payments. It can also increase taxes.

Break-even inflation rate on five-year securities rose from 0.49% to 2.57% in the 14 months between March 31, 2020, and May 31, 2021

A break-even inflation rate is the difference between the yields of inflation-indexed debt and similar maturity Treasuries. This statistic is a measure of market participants’ expectations for inflation.

Historically, the market reaction to inflation has been devastating to muni bond returns. However, over the past few years, a shift in sentiment has been observed. As a result, the return on the investment grade bond market has improved over the past three months.

Break-even inflation rates have been on the rise since March 2020. The latest value indicates that market participants are optimistic that inflation will pick up in the near future.

The break-even inflation rate is calculated by dividing the nominal yield of 5-year Treasury Inflation-Indexed Constant Maturity Securities (TIPS) by the real yield of a comparable-maturity Treasury security. While this is not a perfect calculation, it is considered the most accurate for identifying market-based expectations for inflation.

According to the Bureau of Labor Statistics, the break-even inflation rate has exceeded its predecessor, the consumer price index, several times over in recent years. It is not surprising that the market reaction to inflation has often been negative.

Tax efficiencies of muni bonds and CPI swap combo

If you’re worried about a recession and inflation, you may want to consider a municipal bond and CPI swap combo. These two products work well together and can provide tax efficiencies.

The Consumer Price Index (CPI) rose 0.7% in May. This rise is largely a result of pent up consumer demand. A strong economy and record household savings are helping to drive the increase.

Inflation generally increases the cost of doing business. Rising prices can also lead to increased sales and income taxes. Investing in muni bonds and CPI swaps can help to reduce your risk and keep your portfolio insulated against the inevitable spike in inflation.

Historically, inflation protected debt has provided good returns with low volatility. It has also had a low default rate. However, inflation-protected munis can be difficult to find.

Some muni bond issuers have called their bonds, and investors may need to add call protection to their bond portfolio to prevent losing money. Investors can also avoid state and local yield taxes.

Credit spreads for the Bloomberg Taxable Municipal Index widened during the quarter

The Bloomberg Taxable Municipal Index began the quarter at 120bps and ended at 136bps. Credit spreads for the index widened by 9bps over the course of the quarter. Its performance was supported by a rally in Treasury yields. However, the rise in the federal funds rate, as well as a disappointing inflation report, stifled the rally.

Supply volumes decreased during the third quarter. New issuance dropped by a fifth. Issuers are looking for stable markets. But this may not last.

Despite the softer demand, long-term taxable municipal valuations remain attractive. This is especially true compared to similarly rated corporate bonds.

Supply volume for the period was also lower than the same time a year ago. Market-moving events lowered volumes in September. Nevertheless, there is still room for a rebound.

Several EM issuers retained strong credit profiles. Some can even retire their debt at discount levels. However, global risk-off conditions and the war in Ukraine contributed to a wider spread.