Municipal bonds won an endorsement from Merrill Lynch Wealth Management investment chief Ashvin B. Chhabra, who said they offer attractive yields in the current low rate environment without the risks of other fixed income securities.
Tax benefits combined with municipalities' overall improving fiscal health enhance the attraction of the asset class at a time when tax increases are prevalent and Merrill believes interest rates in general will remain lower for a longer period, Chhabra wrote in his chief investment officer report issued this week.
"Municipal bonds remain one of our favored segments, with relatively attractive yield and positive fundamentals," he wrote. "Within a goals-based framework, municipal bonds may have a role within the bucket of assets providing a safe store of value, and laddering using municipals can provide a secure source of income."
The firm's positive view on municipals stems from three advantages currently offered by the asset class - the tax benefits in a rising tax environment, overall improvements in municipalities' fiscal issues, such as pension funding, and generally rising revenue among states and municipalities.
"In our view, these factors trump the headline risks arising from struggling issuers like Detroit and Puerto Rico," Chhabra, who is also head of investment management and guidance, wrote in the report.
He said those and other distressed municipalities indicate there is risk in the market, but that it would be "misleading" to view them as representative of the overall municipal bond market.
"While fiscal issues in some municipalities continue to generate negative headlines, most have taken steps to close gaps in ailing pension systems and to reform them," he wrote. "Most state and local governments stand on solid footing, having made significant progress in pension reform and closing budget gaps."
These fiscal improvements highlight the benefits of municipal bonds as an asset class.
"Sales tax receipts continue to grow at a healthy clip, though those from personal income taxes remain stagnant," Chhabra said. "Property tax receipts have shown improvement in response to the upturn in home prices."
"Tax revenue is the main source of payment for municipal bond interest and the improvement in government budget balances improves the credit quality of their bonds," he continued.
Market fundamentals also support the attractiveness of municipals as a fixed-income alternative - especially since zero interest-rate policies have forced investors to stretch for yield.
"We think the municipal market is one part of the fixed income world where investors are still sufficiently compensated of the risks they are being asked to take, especially after adjusting for taxes," he wrote.
He said this is especially enticing for investors in the 28% federal income tax bracket or higher.
"While their yields may appear low on an absolute basis, on a relative basis, munis still represent good value versus many taxable bond alternatives," he wrote.
According to the firm, municipal valuations relative to Treasuries remain attractive and both the 10 and 30-year municipal yield as a percentage of Treasuries has exceeded 100% so far in 2015. In fact, the 30-year ratio approached 120% as of March 17, according to data provided in the report.
Additionally, the generally higher credit quality and the historically lower defaults rates when compared to the corporate universe shed a positive light on municipals.
Chhabra pointed out that even as there has been a significant decline in the availability of triple-A-rated paper in recent years since the financial crisis, approximately 90% of the municipal market is A-rated or higher, versus only about 55% for investment grade corporate bonds.
The supply and demand balance is another positive factor supporting municipals, according to Chhabra. Issuance of $300 billion in each of the past two years was eagerly absorbed by the market and municipal bond funds had net inflows every week except three last year, he noted. Net inflows have been positive for most of 2015.
The valuations of municipals relative to Treasuries, he said, remain attractive and munis should be considered an option by taxable investors looking to reallocate a portion of their core fixed-income portfolios. He noted that historically, total returns of U.S. municipals have risen as U.S. equities have fallen.
"Like U.S. Treasuries, we think municipals can provide diversification for portfolios that are heavy on equities," Chhabra wrote.
