Jeffrey Burger, Senior Portfolio Manager, Insight Investment, writes that his firm believes US municipal bonds offer a compelling opportunity to access high-quality, yield-enhancing assets. Their structural diversity, credit resilience, and alignment with infrastructure investment themes have the potential to make them a valuable addition to global portfolios.
US municipal bonds are debt securities issued by states, cities, counties, and other governmental entities to fund public projects such as schools, highways, airports and water systems. These bonds offer investors a way to earn interest while supporting infrastructure and community development. Bonds issued by a state and funded via tax revenues are known as general obligation (GO) bonds, while bonds secured by the income stream of an infrastructure asset are known as revenue bonds.
US municipal bonds come in two primary forms:
• Taxable Bonds: Interest income is subject to taxation, making them more suitable for non-US investors, who do not benefit from US tax exemptions. These bonds often offer higher yields to compensate for the lack of tax benefits
• Tax-Exempt Bonds: Interest income is exempt from US federal income tax and often from state and local taxes. These are ideal for US-based investors in higher tax brackets.
In our experience, for many investors outside the US, the municipal bond market remains an underappreciated asset class.
Taxable municipal revenue bonds often offer higher yields than comparable sovereign or corporate bonds. The risk is project-specific in that Investors can assess risk based on the performance of the underlying asset (e.g., airport traffic, utility usage). These assets offer currency diversification because exposure to US dollar-denominated assets can hedge against local currency volatility. They also benefit from a strong legal framework because U.S. municipal bonds operate within a well-regulated and transparent legal environment.
Opportunities offered by a fragmented market:
The US municipal bond market comprises 61,000 issuers, approximately eight times the number of US corporates. In our view, this greater level of fragmentation presents significant opportunities for active managers to add value. However, capitalising on these opportunities demands rigorous credit analysis by a dedicated specialist team. In the case of revenue bonds, this entails a meticulous assessment of the unique risks and characteristics associated with the underlying infrastructure assets of each instrument.
Strong credit fundamentals
In aggregate, current municipal credit conditions are supportive for the asset class, bolstered by healthy state balance sheets and prudent management of cash reserves. For example, state total balances – combination of cash reserves that state governments set aside to help cover unexpected budget shortfalls or revenue declines and general fund ending balance – remain near the highest levels seen in decades, projected to reach USD 287billion in 2026. Likewise, the median level of state total cash balances remains well above pre-pandemic levels.
Municipal fundamentals are further bolstered by strong revenue collection, with most states reporting revenue collections exceeding budget projections. In cases where revenues fell short, reduced spending helped maintain budget surpluses, allowing states to build reserves and reduce debt. In addition, the aggregate revenues are expected to grow by 1.9 per cent in fiscal year 2025 versus fiscal year 2024, highlighting the strength underlying the municipal bond market.
Strong historical resilience and credit quality relative to US corporates
The quasi-public nature of municipal bonds has resulted in significantly lower historical default rates and higher recovery rates than global corporate bonds. For example, from 1970 to 2022, investment grade muni bonds, from AAA to BBB, experienced a cumulative default rate of only 0.09 per cent versus 2.23 per cent of IG global corporates within 10 years of issuance. In addition, this cumulative default rate is around one quarter of the average default rate for US AAA corporates of 0.34 per cent.
The asset class has also exhibited a historically higher aggregate credit quality than US corporates. According to Moody’s Investors, around 92 per cent of the universe boasting ratings of A3 and above versus 26 per cent for global corporates.
In our view, municipal revenue bonds possess several advantages over general obligation bonds, such as strong credit fundamentals, greater insulation from political risk and historically attractive yields. We believe these characteristics, in combination with a focus on high-quality, stable issuers in economically strong services areas, represent bond income sources that are better insulated from economic slowdowns than tax-reliant general obligation (GO) bonds.
