Munis in Focus: Preparing for Late-Cycle Certainties


  • We believe the tax-exempt municipal market may offer attractive benefits to U.S. investors late in this economic expansion.
  • Municipal bonds have tended to outperform taxable fixed income asset classes when rates are rising and offer lower correlations with equities. Limited muni supply will also likely remain a tailwind to performance.
  • Credit quality will likely be a key performance driver when the economic cycle turns, making strong research and active selection critical.

It’s often said that the only certainties in life are death and taxes, but for investors, it could be argued that the two key certainties are taxes and recessions. The current economic expansion is now the second-longest in the postwar era, at 110 months; only the expansion ended in 2001 outlasted it, and by a mere 12 months. And while predicting the end of a business cycle is notoriously difficult, we view a recession as likely over the secular (three- to five-year) horizon.

We think investors should be readying their portfolios for this eventuality – and the tax-exempt municipal market has displayed a number of characteristics historically that could make it attractive for U.S. taxpayers late in this expansion.

Municipal bonds have outperformed when rates are rising

Municipal bonds have tended to outperform taxable fixed income asset classes as rates rise, and Federal Reserve rate hikes are a fixture of late-cycle markets. The Fed has hiked the overnight rate by 125 basis points (bps) since the beginning of 2017, and PIMCO expects further hikes this year and next. On a pretax basis, munis have outperformed taxable investment grade corporate bonds in three of the last four Fed tightening cycles (as proxied by the Bloomberg Barclays Municipal Bond Index and Bloomberg Barclays Investment Grade Corporate Bond Index). On an after-tax basis, the benefit has been more pronounced: Munis have outperformed investment grade credit, U.S. Treasuries and mortgages (as proxied by the Bloomberg Barclays U.S. Agency Fixed Rate MBS Index) in all four tightening cycles since 1987.

Munis offer greater diversification from stocks

Munis also have lower correlations to risk assets than many taxable fixed income alternatives. Over the past decade, both investment grade and high yield munis have shown about one-third the correlation to equities compared with their taxable counterparts. Over the past 20 years, during periods when the S&P 500 declined at least 10%, munis outperformed equities by an average of 23% and investment grade corporate bonds by an average of 1.33% after accounting for federal income taxes (see Figure 1).

Munis in Focus: Preparing for Late-Cycle Certainties – PIMCO

Tax-free carry helps reduce the “cost” of waiting for a potential shift in the cycle, without taking on additional credit risk. Investment grade and high yield munis currently offer approximately 50 bps and 165 bps of potential after-tax pickup for U.S. taxpayers, respectively (see Figure 2), with default rates that remain low relative to other asset classes.

Munis in Focus: Preparing for Late-Cycle Certainties – PIMCO