Muni Bond Market on Pace for $580 Billion in New Issuance This Year, BlackRock Says

Municipal bond issuance is on pace to top $580 billion this year, according to BlackRock. That would be one of the biggest years on record for state and local governments raising money through the bond market.

Investors are showing up too. New cash flowing into municipal bonds hit $56.6 billion in the first half of the year, the second-best start to any year on record, according to BlackRock's tally.

Patrick Haskell, who heads BlackRock's municipal bond group, says the setup for the rest of the year requires some discipline. "The key for the second half will be patience," Haskell said. "There will be opportunities, but you want to buy the right credits, the right structures and the right levels. We are cautiously optimistic in the second half."

Why rich people love these bonds

Municipal bonds have long been a favorite parking spot for high-income investors, and the math explains why. States, cities and local authorities issue munis to fund everything from schools to highways to water systems, and the interest is generally exempt from federal income tax. If you live in the state that issued the bond, you often skip state and local taxes on that income too.

That tax break is worth more the higher your bracket. BlackRock's numbers show it plainly: someone in the 32% federal bracket who also pays the net investment income tax would need a taxable bond yielding 5.45% just to match what a 3.5% tax-free muni pays out. For a doctor, business owner or anyone else getting hammered by federal withholding, that's not a small difference.

Municipal bonds aren't risk-free, and they aren't attractive to everyone. Someone in a lower tax bracket generally comes out ahead in a taxable bond instead. And munis carry real risks tied to the finances of the issuing city, county or state, from pension shortfalls to declining tax bases. Detroit's 2013 bankruptcy and Puerto Rico's debt crisis are reminders that "backed by a government" doesn't mean "guaranteed."

Where BlackRock is putting money

Haskell's team says it's staying neutral on overall interest-rate exposure but likes the long end of the muni curve, specifically bonds maturing in 20 to 22 years. Longer-dated bonds carry more duration risk, meaning their prices swing harder when interest rates move. Haskell argues investors are getting paid enough extra yield in that stretch to justify the risk. "If you want to take duration risk, you'll want to do it in muni bonds because you get compensated for that risk," he said.

The firm is also favoring higher-quality issuers and bonds with coupons above 5%, while trimming exposure to lower-coupon bonds it views as less able to hold up if markets get rocky. Within that, Haskell's team likes revenue bonds tied to housing and transportation. Unlike general obligation bonds backed by a government's full taxing power, revenue bonds are paid back from a specific income stream, like toll collections or rents from housing projects.

The numbers back up why housing bonds in particular are getting attention. The S&P Municipal Bond Housing Index has a yield-to-worst of 4.34%, according to BlackRock. On a tax-equivalent basis, for someone paying an effective 40.8% tax rate, that works out to a 7.33% yield. Yield-to-worst is the most conservative measure of return, accounting for the possibility that a bond gets called or redeemed early.

What's not resolved yet

Municipal bond markets can get choppy fast if there's a scare about state budgets, pension obligations, or federal funding cuts to states and cities. BlackRock's own framing, urging "patience" and "cautious optimism," reflects the uncertainty.

There's also a structural question hanging over the sector: federal tax policy. Congress has floated capping or eliminating the municipal bond tax exemption in past budget fights as a way to raise revenue, and that possibility resurfaces periodically in Washington. If that exemption were ever curtailed, the entire value proposition Haskell is describing would shrink overnight. No such change has been enacted, and none is currently pending, but it remains a standing risk factor for anyone parking serious money in this corner of the bond market for the next two decades.