The Case for Municipal Bonds in a Rising-Rate Environment

Municipal bond yields moved higher in 2018 and seem likely to continue moving up in 2019 if market expectations for further interest-rate increases play out. Sheila Amoroso, director of Franklin Templeton Fixed Income Group’s Municipal Bond Department, makes a case for munis within a rising-rate environment. She says there could actually be more demand for munis ahead as a source of tax-free income.

During 2018 we saw some volatility in the municipal bond market for the first time since the fourth quarter of 2016. Municipal bond yields moved higher across the yield curve throughout the year with the yield curve steepening, unlike the US Treasury market, which has seen a flattening of the yield curve.

Given the expected path for US Federal Reserve rate hikes and underlying macroeconomic fundamentals in the United States, we expect broader interest rates to continue moving higher during 2019, along with municipal bond yields. However, we do expect the moves to be more gradual, as opposed to sizable short-term increases.

Because of the higher yields available in the market, there is a greater opportunity to earn tax-free income in the municipal bond asset class. It is important to remember that as municipal bond yields move higher, the taxable equivalent yield moves exponentially higher, particularly for higher-tax states. This new higher base of tax-free income available in the market could help spur demand for the asset class in 2019.

US Tax Reform Impacts

The impacts of the tax reform bill that was passed at the end of 2017 will be felt more directly by investors in 2019. Specifically, with the cap on SALT (state and local tax) deductions at $10,000, we expect demand to increase for municipal bonds, particularly from higher tax states. While we haven’t experienced a material increase in such demand as of this writing, we tend to see a shift in demand only after the impact is felt during the tax period by investors. Therefore, we believe a pickup is likely after the impact of the cap is fully felt in early 2019 during the tax preparation season. We also expect that if we were to see such increased demand, it would help to lower yield volatility in a general up-trending yield environment.