Line graph tracks U.S. investment grade fixed income, U.S. municipal fixed income, and U.S. municipal tax equivalent yield.
Y-axis: Yield to worst (%); X-axis: March 2017 – March 2022.
Yields generally parallel each other, with tax-equivalent yield often highest (near 1.3% at the end of Q2 2021). Since mid-2018, however, investment grade has tracked and sometimes surpassed tax-equivalent yield (as at the end of Q4 2021, when it was near 1.8%). Municipal fixed income yield was generally lowest in this period, (though from April 2020 through much of the year, it exceeded investment grade fixed income).
All three measures had generally been declining from highs above 3.5% for tax equivalent and investment grade and above 3.0% for municipal fixed income since November of 2018. However, in March of 2020 all three bond yields spiked up sharply (muni tax equivalent yield near 4.4%, muni fixed income about 3.5%, and investment grade fixed income near 2.3%). By the end of August 2020 yields had settled to about 1.2% (investment grade), 1.3% (municipal fixed income), and 1.6% (municipal tax-equivalent yield). As of Q1 2022 they were about 2.9%, 2.6%, and 3.2%, respectively.
Municipal bonds have lower historical default rates versus corporates
| Credit rating | Municipal bonds (%) | Corporate bonds (%) |
|---|---|---|
| Aaa | 0.00 | 0.35 |
| Aa | 0.02 | 0.77 |
| A | 0.10 | 2.04 |
| Baa | 1.09 | 3.61 |
| Ba | 3.48 | 15.27 |
| B | 17.07 | 34.27 |
| Caa-C | 24.36 | 51.48 |
| Investment-grade | 0.10 | 2.24 |
| Speculative-grade | 7.11 | 29.66 |
Sources: Top chart: Bloomberg and Wells Fargo Investment Institute. Yield to worst: monthly data from March 1, 2017 to March 31, 2022. Bottom table: Moody’s Investor Service, “U.S. municipal bond defaults and recoveries, 1970-2020”. Municipal and corporate bond default rates: 10-year average cumulative default rates, yearly data from 1970 to 2020. Investment grade represented by Bloomberg U.S. Aggregate Bond Index. Municipal represented by Bloomberg Municipal Bond Index. For illustrative purposes only. Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. Bloomberg Municipal Bond Index is an index of a broad range of investment-grade municipal bonds that measures the performance of the general municipal bond market. Index returns do not represent investment performance or the results of actual trading. Index returns represent general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. Yields represent past performance and fluctuate with market conditions. An index is unmanaged and not available for direct investment. Current yields may be higher or lower than those quoted above. Past performance is no guarantee of future results.
Tax equivalent yield assumes a 20% effective tax rate. Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The tax equivalent yield is the yield a taxable bond would have to earn to match the yield available on a tax-exempt municipal bond excluding AMT. Yield to Worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes and may be subject to the alternative minimum tax, and legislative and regulatory risk.
Key Takeaways
- We expect municipal demand to remain strong given the ongoing supply-demand imbalance.
- The pace of municipal defaults has accelerated over the past decade, especially for lower-rated sectors. Still, default rates between municipals and corporates remain divergent in the speculative-grade (high-yield) space.