The Case For Munis: Staying the Course in a Historic Fixed Income Slump

GW&K Insights | February 2025

Key Takeaways:

While recent fixed income returns have been disappointing, there are several reasons to be optimistic about the asset class:

• Interest rates are above long-term averages, improving future return potential.
• Higher yields assist in offsetting potential price volatility.
• Fixed income has historically provided downside protection during stock market corrections.

Recent Bond Returns Have Been the Worst in History

Over the past three years, fixed-income investors have experienced the worst bond market in history. Meanwhile, equities have performed exceptionally well, drawing even more attention to these meager returns. During this period, municipal bonds recorded their first-ever negative return (Figure 1), whereas the S&P 500 returned 8.94% per year. These vastly different results have investors questioning why they own bonds at all.

How Did We Get Here?

Beginning during the Global Financial Crisis of 2007 – 2009, the US Federal Reserve (Fed) engineered a period of zero rates to combat deflation that lasted for over a decade. However, over the last three years, inflation emerged from its deep sleep and interest rates spiked. As a result, the 10-Year AAA muni rate rose nearly 300 basis points from its all-time low of 0.68% in early 2021 (Figure 2). The historically low initial yield meant that the losses inflicted on bond investors were even more extreme than prior periods of rising rates when there was more “coupon cushion.”

The Good News

With a new and improved yield, the prospects for returns moving forward have increased significantly. And these higher yields also provide a buffer against future increases in rates, unlike the period investors just experienced. Bond market participants are now presented with favorable upside relative to downside risk. Figure 3 illustrates this dynamic by showing returns in rising/declining rate scenarios.

Don’t Forget Why You Own Bonds

While simply generating income is a fair objective, given the possibility for future volatility in risk markets, a potentially even more important reason to own bonds is for portfolio protection. Fixed income serves as the sleep-well-at-night portion of your investment allocation, acting as a hedge if and when the stock market corrects. Figure 4 examines the current high valuations of the stock market and Figure 5 shows the performance of municipal bonds during equity corrections.

Rough Patches Don’t Last — But Diversification Always Matters

With today’s higher rates, fixed income provides reliable income, reduces portfolio volatility, and enhances risk-adjusted returns. Instead of abandoning bonds for a crowded equity market, investors should view fixed income as a crucial component of a well- balanced portfolio offering diversification, capital preservation, and income generation — especially in these times of uncertainty.