With a possible recession on the horizon, many investors are probably looking for investment opportunities that could help provide security in a difficult market environment. U.S. municipal bonds are one possibility. The U.S. seems intent on accelerating infrastructure spending, and if that happens, the market for municipal infrastructure bonds could become even more robust.

Municipal bonds offer the potential for appealing returns backed by infrastructure projects, such as solar power, hospitals, and schools. Their underlying revenue streams tend to be predictable and stable, which support their higher credit quality and lower correlation to equities compared with corporate bonds.

What is municipal infrastructure, and how is it financed?

The roughly 19,500 municipalities across the U.S. are local governments below the state level. Municipalities’ governing bodies provide public services for their local populations—like police and fire stations, roads, schools, events centers, city water, and sewer systems—all of which are considered municipal infrastructure.

Municipalities generally pay for the construction, maintenance, and updating of infrastructure by issuing taxable bonds. As of September 2022, the U.S. taxable municipal bond universe consisted of around 10,000 securities with a market capitalization of close to $400 billion. Of the $400 billion, approximately $300 billion (75%) constituted revenue bonds, which fulfill their obligations to investors using revenue derived from the underlying infrastructure projects.[1] The breadth of U.S. revenue bonds available provides a wide range of opportunities for infrastructure investment.

Municipal infrastructure may offer attractive risk-adjusted returns.

Because infrastructure projects underlie revenue bonds, the risk drivers for taxable municipal bonds can be different from those of corporate bonds. From a risk perspective, this means municipal infrastructure can act as a diversifier to corporate bonds within a portfolio. Yet, the returns can be very competitive compared with corporate bonds.

Also, municipal infrastructure bonds have tended to be less correlated to equities than other types of bonds—in other words, they tend to be less likely than other bonds to move in the same direction as equities. The returns of municipal infrastructure bonds coupled with their generally lower correlation to equities can be particularly appealing, especially in comparison with other types of bonds, as seen in Figure 1.

Index definitions

Municipal infrastructure bonds have had lower default risk than corporates.

A common concern for bond investors is the risk of default—that a bond issuer isn’t able to make its required payments to investors. Municipal infrastructure bonds have had a strong track record in this area. In Figure 2, historical comparisons between the cumulative default rates for municipal infrastructure bonds and corporate bonds at all levels of quality show much lower default rates for municipal infrastructure bonds across the board.

Even the cumulative default rate for lower-quality BBB-rated municipal infrastructure bonds has been better than the rate for high-quality AAA-rated corporate debt.

The available breadth in the municipal infrastructure bond market means that portfolios can be customized to meet sustainability, cash flow, and regulatory requirements. The size of the market also gives ample opportunity to add value through security selection.

For U.S. investors who are not subject to taxes or who may have tax-sheltered accounts, taxable municipal bonds can offer the potential for attractive risk-adjusted returns that help diversify a portfolio. These bonds also may provide investors the opportunity to help fund projects that have tangible social or environmental benefits.

For insurance companies in the European Union, many taxable municipal bonds may confer an additional advantage, thanks to how regulators treat these bonds. The favorable regulatory treatment can be a substantial benefit.

We believe the potential for better risk-adjusted returns, better diversification, and better outcomes for the planet and underserved populations are compelling reasons for considering municipal infrastructure bonds.

 

Disclosure

1. Bloomberg Taxable Municipal Index, as of September 2022

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

The ratings indicated are from Standard & Poor’s, Moody’s Investors Service, and/or Fitch Ratings Ltd. Credit-quality ratings: Credit-quality ratings apply to underlying holdings of the fund and not the fund itself. Standard & Poor’s rates the creditworthiness of bonds from AAA (highest) to D (lowest). Standard & Poor’s rates the creditworthiness of short-term notes from SP-1 (highest) to SP-3 (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody’s rates the creditworthiness of bonds from Aaa (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Moody’s rates the creditworthiness of short-term U.S. tax-exempt municipal securities from MIG 1/VMIG 1 (highest) to SG (lowest). Moody’s rates the creditworthiness of short-term securities from P-1 (highest) to P-3 (lowest). Fitch rates the creditworthiness of bonds from AAA (highest) to D (lowest).

Allspring Global Investments does not provide accounting, legal, or tax advice or investment recommendations.

Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.

PAR-0922-00596

 

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