Munis: Tax-Free Income in Times of Stress

Summary

Munis: Tax-Free Income in Times of Stress
Thoughts on the Market – Morgan Stanley Podcast Episode Summary
Release Date: May 5, 2025

Morgan Stanley’s podcast, “Thoughts on the Market,” offers insightful analyses on recent market events through various expert perspectives within the firm. In the episode titled “Munis: Tax-Free Income in Times of Stress,” released on May 5, 2025, host Mark Schmidt engages in a comprehensive discussion with Craig Brandon, co-director of Municipal Investments at Morgan Stanley Investment Management. The episode delves into the intricacies of the municipal bond market, examining recent challenges, enduring strengths, and strategic considerations for investors.

Introduction to the Municipal Bond Market

Mark Schmidt opens the discussion by highlighting the significance of municipal bonds, a colossal $4 trillion asset class often underrepresented in mainstream financial conversations. He emphasizes that municipal bonds (munis) are integral to everyday infrastructure and public services, including driving, flying, schooling, and essential utilities. Despite being considered a late-cycle haven, munis recently faced volatility, prompting a deeper exploration of the factors at play.

April's Market Turbulence for Municipal Bonds

Craig Brandon elucidates the tumultuous market conditions experienced in April, describing it as a "trifecta of things that were a little different than other asset classes" [00:35]. He outlines three primary factors contributing to the volatility:

1. Rising Treasury Rates:
   Munis are closely correlated with Treasury bonds as a duration asset class. An increase in Treasury rates typically leads to a withdrawal of funds from the muni market. Brandon notes, “When we see rates going up, you generally see money coming out of the market” [00:35].

2. Tax Exemption Uncertainty:
   Ongoing discussions in Washington D.C. regarding the potential loss of tax exemptions for munis caused issuers to accelerate bond issuance. This surge in supply amidst declining demand exacerbated market stress. Brandon explains, “If you're an infrastructure issuer... you want to get these bonds issued today” [01:05].

3. Economic Concerns:
   Conversations about potential credit weaknesses driven by a slowing economy added to investor apprehension. Although Brandon considers this the "distant third," it still played a role in the overall market dynamics [02:04].

Comparing Current Volatility to Past Market Sell-Offs

Drawing from his extensive experience through multiple market crises, Brandon contrasts the current situation with the 2008 financial crisis. He reflects, “In 2008, we were really sitting on a trading desk wondering where this was going to end” [02:13]. Unlike the pervasive uncertainty of 2008, the present volatility feels more transient and less indicative of a fundamental market restructuring. This perspective provides a sense of reassurance regarding the resilience of the municipal bond market.

Fiscal Health of State and Local Governments

Mark Schmidt raises concerns about the fiscal health of state and local governments amid a projected economic slowdown. Brandon responds by highlighting the strong balance sheets many issuers maintain, bolstered by substantial federal infrastructure spending during the COVID-19 pandemic. He asserts, “We're going into this crisis with a lot of cash on balance sheets, allowing issuers to be able to withstand some weakness in the economy and get through to the other side of this” [03:49]. This financial cushion positions municipal issuers to navigate economic headwinds effectively.

Municipal Yields vs. US Treasuries

Addressing the relative performance of muni yields compared to US Treasuries, Brandon explains that munis underperformed due to their more retail-driven nature. Unlike investment-grade corporates and Treasuries, which attract substantial institutional investment, the muni market is predominantly supported by retail investors. Increased volatility leads to retail investors pulling out, thereby weakening muni yields. He observes, “The US Muni market is more retail driven than some other asset classes” [03:59]. This technical aspect, rather than fundamental credit issues, primarily drove the recent yield performance.

The Tax-Free Advantage and Reform Concerns

A central theme of the episode is the tax-free nature of municipal bonds. Schmidt points out that muni bonds have enjoyed federal tax exemptions for over a century, making them an attractive investment for tax-conscious investors. However, concerns about potential tax reform prompted Brandon to offer reassurance. Drawing from his experience with the New York State Assembly Ways and Means Committee, he emphasizes the strong relationships between state officials and Congress. Brandon confidently states, “Members of Congress and members of the Senate in Washington get it because they were all there when it happened” [05:20]. He recalls that the last significant challenge to the muni exemption in 2012 was effectively managed, suggesting similar resilience today.

Strategies for Investing in Municipal Bonds

Navigating the complexity of the muni market, with its over 50,000 issuers and myriad bond options, can be daunting for individual investors. Brandon advises leveraging professional money managers to gain effective exposure to municipal bonds. He notes, “The muni market can be very confusing because there are just so many bonds out there” [06:37]. Options such as mutual funds, separately managed accounts, and ETFs can help investors access diversified muni portfolios without the need to manage individual bond selections.

Incorporating Munis into a Diversified Portfolio

Concluding the discussion, Brandon underscores the role of municipal bonds as a stable component of diversified investment portfolios. With high credit ratings—often double or AAA—and a low default rate of approximately 0.2%, munis offer reliable, tax-exempt income. He emphasizes their non-negotiable nature, akin to essential expenses, which supports the stability of their revenue streams. “They're one of the more stable asset classes that you see in your overall portfolio” [08:53].

Notable Quotes

• Craig Brandon [00:35]: “When we see rates going up, you generally see money coming out of the market.”
• Craig Brandon [02:13]: “It's not going to be a permanent restructuring of the market.”
• Craig Brandon [03:49]: “We're going into this crisis with a lot of cash on balance sheets, allowing issuers to be able to withstand some weakness in the economy and get through to the other side of this.”
• Craig Brandon [05:20]: “Members of Congress and members of the Senate in Washington get it because they were all there when it happened.”
• Craig Brandon [08:53]: “They can give you generally stable returns, tax exempt income over the long term, and they're one of the more stable asset classes that you see in your overall portfolio.”

Conclusion

Morgan Stanley’s “Thoughts on the Market” episode on municipal bonds provides a thorough examination of the current state and future outlook of the muni market. Despite recent volatility driven by rising Treasury rates and supply-demand dynamics, municipal bonds remain a robust, tax-advantaged investment option. Their strong fiscal backing, low default rates, and tax-free income make them a valuable component of a diversified investment portfolio. For investors seeking stability and tax efficiency, municipal bonds, especially when managed by experienced professionals, offer a compelling avenue for sustained returns in times of economic stress.

Transcript

[Mark Schmidt]

Welcome to Thoughts on the Market. I'm Mark Schmidt, Morgan Stanley's head of Municipal Strategy.

[Craig Brandon]

I'm Craig Brandon, co director of Municipal investments at Morgan Stanley Investment Management.

[Mark Schmidt]

Today, let's talk about the biggest market. You hardly ever hear about municipal bonds, a $4 trillion asset class. It's Monday, May 5th at 10am in Boston. If you've driven, flown, gone to school or turned on a tap, chances are munis made it happen. Although munis are late cycle haven, they were not immune to the latest bout of market volatility. Craig, why was April so tough?

[Craig Brandon]

So what we say in April, it was sort of the trifecta of things that happened that were a little different than other asset classes. The first thing that happened is we saw a significant increase in treasury rates. And munis are generally correlated to Treasuries. We're a very high quality asset class that's viewed as a duration asset class. So one thing we saw were rates going up. When we see rates going up, you generally see money coming out of the market. Right? So I think investors were a little bit impacted by the higher rate, the correlation to Treasuries, the duration, and saw some flows out of the market. Secondly, what we saw is conversation about the tax exemption in Washington D.C. what that did is it caused muni issuers to pull their issuance forward. So if, if you're an infrastructure issuer, you are issuing bonds in the next year to year and a half, you're going to pull that forward because if there's any risk of loss of the tax exemption, you want to get these bonds issued today. So that's basically what drives technicals. It's supply and demand. So what we saw was a decrease in demand because of higher rates, an increase in supply because of issuance being pulled forward. And the third part of the trifecta we refer to is the conversations about the economy. So I would put that it's sort of a distant third, but there's still conversations about maybe credit weakness driven by a slowing economy.

[Mark Schmidt]

Craig, your team has been through a lot of tough market cycles. Given your experience, how did the most recent sell off compare and why was it not like 2008?

[Craig Brandon]

I started my career back in 1998 during the long term capital management crisis. I lived through 2008, I lived through the COVID cris and really when I look at the crisis in 2008, no banks went out of business. Three weeks ago, right. In 2008, we were really sitting on a trading desk wondering where this was going to end. We had A number of meetings with our staff over the last couple weeks explaining to them why it was different and how, yes, there was some volatility here, but you could see that there was going to be an end to this and this was not going to be a permanent restructuring of the market. So I think we felt comfort. It was very different in 2008, and it really felt different than Covid.

[Mark Schmidt]

That's reassuring. But with economic growth set to slow sharply, how does your credit team think the fiscal health of America's state and local governments will hold up?

[Craig Brandon]

Well, remember state and local governments, and when we're talking about munis, we're also talking about other infrastructure asset classes, like water and sewer bonds, like transportation bonds, airports. We're talking about toll roads. They went into this with a very strong balance sheet. Right. Remember, there was a lot of infrastructure money spent by the federal government during COVID to give issuers money to make it through Covid. There's still a lot of money on balance sheets. So what we do is we're going into this crisis with a lot of cash on balance sheets, allowing issuers to be able to withstand some weakness in the economy and get through to the other side of this.

[Mark Schmidt]

Not only do state and local governments have a lot of cash, but they're just not that impacted by tariffs. Right. So why did muni yields perform worse than US Treasuries over the past couple of weeks?

[Craig Brandon]

Right. It really. We're technically driven. Right. The US Muni market is more retail driven than some other asset classes. Remember investment grade corporates, treasury bonds? There's a lot of institutional buyers in those markets. In the municipal market, it's primarily retail driven. So when, you know, individual retail investors get nervous, they tend to pull money out of the market. So what we saw was money coming out of the market. At the same time, we saw an individual increase in more bonds, which just led to very weak technicals, which when we see that, it eventually reverses itself.

[Mark Schmidt]

Now, I almost buried the lead, Right. Why invest in munis? Well, they're great credit quality, but they're also tax free. In fact, muni bonds have been exempt from federal taxes for over a century. You have a lot of experience putting together tax bills, and right now people are worried about tax reform. Do you think investors should be concerned?

[Craig Brandon]

Listen, I'm not really losing a lot of sleep at night over the tax exemption. I think there's other issues to worry about. Why do I say that? As you mentioned, Mark, I spent the early years of my career working for the new York State Assembly Ways and Means Committee. I spent seven years negotiating budgets. And what that did is it gave me a window into how not only state budgets, but the federal budget gets put together. So what it also showed me was the relationship between state and local elected officials and your representatives in Congress and your representatives in the Senate. So I know firsthand that members of Congress and members of the Senate in Washington have very close relationships with members of the state legislatures, with governors, with mayors, with city council members, with school board members who are all delivering the message that significantly higher financing costs that could potentially happen from the loss of the exemption could be meaningful to them. And I think members of Congress and members of the Senate in Washington get it. They understand it because they were all there when it happened. The last time the muni exemption came under fire was back in 2012. And in 2012, a lot of members of Congress were in the state legislature back then. So they understand it.

[Mark Schmidt]

That's reassuring because right now, tax equivalent yields in the muni market are 7 to 8%. That's equal to or greater than the long run rate of return on the stock market. So whether to invest in the muni market seems pretty straightforward. How to invest in the muni market? Well, with 50,000 issuers, that's a little complicated. How do you recommend investors get exposure to tax free munis right now?

[Craig Brandon]

Well, and that is a very common question. The muni market can be very confusing because there are just so many bonds out there, you know, over 50,000 issuers, there's over a million individual cusips in the muni market. So as an individual investor, where do you start? There's different coupon structures, different call structures, different maturity structures, ratings. There's so many different variables that go into a decision in investing in muni bonds. I can make an argument that you could probably mimic the S&P 500 with 500 different stocks. But most muni indices are over 50,000 constituents. It's very difficult to replicate the muni market by yourself, which is why a lot of people, you know, they let professional money managers do the investing for them. Whether you're looking at mutual funds, whether you're looking at separately managed accounts, whether you're looking at Exchange traded fund ETFs. There's a lot of different ways to get exposure to the muni market. But with the huge amount of choices you have to make, I think a lot of individual investors would just let a professional with the experience do it.

[Mark Schmidt]

And active managers let you customize portfolios to your unique tax situation and risk tolerance. So Craig, a final question for you. How do munis fit into a diversified portfolio?

[Craig Brandon]

Munis are generally the stable part of most people's portfolios. Remember, you don't have a choice of whether you're going to pay your taxes or not. You have to pay your taxes, you have to pay your water bill, you have to pay your power bill, you have to pay tolls on highways, you have to pay airport fees when you buy an airline ticket. Right? It's not an option. So because the revenue streams are so stable, you see most muni bonds rated double or AAA, the default rate for rated munis is significantly below 1%. It's something in the ballpark of about 0.2%. So with such a low default rate, listen, we're technically driven. As I said, you see ups and downs in the market, but over a longer period of time, munis can give you generally stable returns, tax exempt income over the long term, and they're one of the more stable asset classes that you see in your overall portfolio.

[Mark Schmidt]

That sounds boring and I mean that in the best possible way. Craig, thanks so much for your time today.

[Craig Brandon]

Thanks Mark.

[Mark Schmidt]

Happy to be here and thank you for listening. If you enjoy thoughts on the market, please leave us A Review Wherever you listen and share the podcast with a friend or colleague today, the proceeding content.

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