Bonds Are Getting Pricey. Munis Still Look Cheap and Could Rally.

Muni bonds look attractive lately for a number of reasons. (John Moore/Getty Images)

Key Points

About This Summary

• Attractive yields are hard to find in the bond market, but municipal bonds are an exception.
• Corporate bonds have historically narrow spreads to Treasury bonds, but municipal bonds are historically generous.
• Investors have been jumping on the muni trade in the past month, pouring more than net $2 billion into ETFs.

In many corners of the bond market, it can be difficult for investors to find attractive yields. In contrast, municipal bonds still look like a bargain.

The Federal Reserve’s decision earlier this week to cut short-term interest rates poses a threat to income investors. It likely means smaller payouts from CDs, money-market funds, and other yield instruments.

For investors in long-term instruments such as bond mutual funds, the blow is less severe. Long-term interest rates don’t move in lockstep with the short-term federal-funds rate, and when rates do come down, investors can count on rising bond prices to cushion the blow. (Bond prices move in the opposite direction to rates.)

Still, these bond investors face a separate problem: Both investment grade and high-yield corporate bonds have been trading at historically narrow spreads to Treasury bonds. That means investors aren’t getting paid much to take on the extra risk these bonds entail.

Yields on investment-grade corporate bonds exceed those of similarly dated Treasury bonds by only about 0.75 percentage points, according to data compiled by the St. Louis Fed. It’s the smallest yield premium investors have been able to count on in at least a decade.

The good news: While payouts on corporate bonds are historically stingy relative to government bonds, those of another portfolio staple, long-term municipal bonds, are historically generous.

“Munis are the most undervalued fixed income asset class,” wrote a BofA Securities team led by Yingchen Li in a note Friday. Yields for triple-A-rated 30-year municipal bonds currently stand at 4.21%, according to FactSet. That amounts to about 89% of the 4.73% yield on 30-year Treasuries—above the long-term historical average of around 85%.

Highly rated municipal bonds offer lower yields than Treasuries because municipal bond interest is exempt from federal income tax, and sometimes state and local taxes, too. For an investor in the 25% tax bracket a muni bond that yielded 75% what a comparable Treasury bond paid would break even. Current spreads, which are much more favorable than that, suggest investors in the 25% tax bracket, or a higher one, would come out well ahead.

Muni bonds look attractive lately for a number of reasons. Earlier this year, in the run-up to the so-called One Big Beautiful Bill Act, lawmakers bandied about the idea of curtailing munis’ tax benefits. It didn’t end up happening, but it initially spooked investors.

At the same time, a host of state and city governments have been rushing to borrow, a dynamic that has led to an oversupply of longer-term muni bonds hitting the market.

BofA Securities analysts also point to some technical factors, such as shifts in the bonds’ duration and price discounts that can affect tax treatment when investors trade bonds.

Investors have been jumping on the muni trade in the past month, pouring more than net $2 billion into municipal bond exchange-traded funds, according to FactSet. The lion’s share has gone to the two most popular funds, the $40 billion iShares National Muni Bond ETF and the $40 billion Vanguard Tax-Exempt Bond ETF.

That has driven up muni bond prices somewhat. The iShares National Muni Bond ETF has returned 2.7% in the past four weeks compared with 1.8% for iShares’ equivalent broad bond market index fund. Still, BofA Securities thinks munis still have further to run, given that plenty of long-dated municipal bonds still trade at historic discounts to similar Treasuries.

“The bulk of the outperformance has not arrived yet,” the firm wrote.

Write to Ian Salisbury at ian.salisbury@barrons.com