The Lure of Municipal Bond Funds Amid Current U.S. Economic Uncertainty

Amidst a looming recession, as observed through the inversion of the yield curve, and investor skepticism regarding a deal with China, the Federal Reserve System’s decision to gradually lower interest rates to stimulate the economy provides an often tax-free and dividend-paying opportunity for investors: municipal bond funds. In truth, a recession is rather unpredictable; the prospect of such a recession, however, has imbued markets with investor skepticism and consequently higher stock volatility. Current political trends have only amplified this sentiment. As a result of economic and political pressure, the Federal Reserve Board finds itself in a rather precarious quandary regarding how it should dictate its economic policy. The solutions proposed thus far by the Federal Reserve Board give rise to the increased attractiveness of municipal bond funds.

The municipal bond market is one often overlooked by investors; typically regarded as a conservative portfolio holding, few aggressively invest in such funds, yet their recent performance—with year-to-date yields as high as 13 percent—suggests that there is more to be had. To understand how the current political and economic climate affects municipal bonds and even speaks to the future performance of such markets, it is first necessary to scrutinize the structure of municipal bonds and their relations to economic conditions.

Municipal bonds are debt securities— money borrowed that must be repaid with a fixed amount, specific maturity dates and (usually) specific interest rates—issued by states, municipalities or counties. Generally, the borrowed money is utilized to fund societal expenditures. The construction of various infrastructures such as public schools is often financed through municipal bonds. Accordingly, municipal bond funds, which invest in municipal bonds, are essentially loaning money to governments and institutions. According to Fidelity, such funds are always exempt from federal taxes and, in certain cases, exempt from state taxes as well. As such, they present highly interesting opportunities, especially for those in high tax brackets.

There are many factors that dictate the value of a municipal bond. Among such factors are relative coupon rates, which are determined by the fluctuation of federal interest rates. It is this relationship that currently makes municipal bond funds a very attractive investment. Each bond is issued with a particular coupon rate. If interest rates increase, new bonds will be issued with higher coupon rates than existing bonds. In response, the value of the existing bond decreases. The opposite is true as well: if interest rates decrease, new bonds will be issued with lower coupon rates than existing bonds. Thus, the value of the original bond increases. Current municipal bonds are already being issued with relatively high coupon rates, giving investors fruitful monthly or quarterly incomes.

The real value of this investment, however, lies in the fact that bonds can greatly appreciate in the event that rates decline—this is due to the fact that the value of original bonds (prior to the interest rate decrease) will be higher than newly issued ones. Interest rates are often cyclical. Following sustained periods of high interest rates, the Federal Reserve Board often begins cutting rates for a myriad of reasons. Generally, cutting interest rates is intended to stimulate the economy. This year, the Federal Reserve Board has already cut rates twice in July and September, in order to mitigate the economic slowdown engendered by the U.S.-China trade war. When cutting rates, the Federal Reserve Board’s Chairman Jerome Powell has left open the possibility for further rate cuts should the economy necessitate it.

The U.S.-China trade war and dim economic outlooks are perhaps not the only factors that have influenced the Federal Reserve Board to trend in this direction. Political pressure and recent market economic shortcomings have likely had similar effects. Soon after Powell announced the decision to lower rates by a quarter point, President Donald Trump, who has been assailing the Federal Reserve for quite some time, tweeted on September 18, 2019: “Jay Powell and the Federal Reserve Fail Again. No ‘guts,’ no sense, no vision! A terrible communicator!” Clearly, the Fed’s announcement failed to produce concord between its leadership and Trump. Indeed, interest rates between 1.75 percent and 2 percent are not exactly what Trump had been hoping for. Rather, Trump tweeted on September 11, 2019 that, “The Federal Reserve should get our interest rates down to ZERO, or less, and we should then start to refinance our debt.” Concluding a series of concerted attacks on the Federal Reserve’s economic policies, Trump called the Federal Reserve’s members “Boneheads.”

Nonetheless, Chairman Jerome Powell has been steadfast in his loyalty to an economic policy shielded from the world of politics. According to The New York Times, Powell said that President Trump’s desired interest rates were not being considered by the Federal Reserve. Still, some perceive the rate cuts as the Federal Reserve succumbing to political pressure.

Other economic circumstances further heighten the chance for the Federal Reserve to cut rates once again. For example, the Institute for Supply Management recently revealed that the manufacturing index fell to its lowest point in ten years. The market has recently seen relatively high volatility. Between political pressure, the shortcomings of certain industries, investor skepticism, failures to form a concrete U.S.-China trade deal and recent literature apprehensive about a looming recession, the Federal Reserve is poised to lower interest rates at least once again.

Should current political realities cause the Federal Reserve to lower interest rates, municipal bond funds will undoubtedly burgeon. The conservative and low-yielding portfolio holding truly carries the potential to provide high yields as bond values increase when interest rates decrease. Such investment returns are even more attractive due to their tax-free nature. The current political and economic climate is conducive to low interest rate policies; the likelihood of the continuation of these policies provide investors with a fruitful and high-yielding opportunity: municipal bond funds.

Like all investments though, municipal bonds may not be for the faint-hearted. Short- term fluctuations in political sentiment, caused by the premise of a potential partial trade deal with China, for example, can result in an increase in prevailing U.S. treasury rates and consequently an increase in municipal bond rates, which in turn can undermine the value of municipal bonds. Thus, municipal bond investments may be best suited for investors who are interested in investing over a longer time horizon, such as one or two years, and who are willing to “ride out” such fluctuations.