Here’s a Steady Investment, and It’s Tax Free

Question: Is it true municipal bonds might be a good investment as the economy slows down?

Answer: Let’s be honest. Bonds are boring, particularly those issued by governments. They generally don’t have significant credit risk. They won’t double in value because of a speculative frenzy over artificial intelligence. And you won’t hear CNBC’s Jim Cramer pounding the table about buying the Piscataway (N.J.) school district’s 10-year bonds. With that admission out of the way, lower-risk municipal bonds are particularly attractive right now. First and foremost, they are tax free. And with interest rates higher right now, there’s a better return on fixed-income investments. Plus, these government credits tend to be resilient in economic downturns and might even provide a small amount of capital appreciation.

But wait! Haven’t muni bonds gone down in recent years and poorly performed this year? Yes, but unlike stocks, we know that bonds will recover their values. Interest-rate hikes cause bonds to lose their current market value, but as the bond approaches maturity, it regains that value paying its face value plus income, giving you the yield that you originally signed up for. This is contrary to a stock, which must increase its earnings to recover the value lost by higher interest rates.

Aren’t muni-bond interest rates still kind of low? That depends on how you define low. A couple years ago, rates were close to zero; now a five-year AA municipal bond earns about 3.125%, or the taxable equivalent of about 5.2% (depending on your tax rate). Adding to their attractiveness, muni bonds could earn more than their yield without taking additional risk.

If there is a recession, or even just a stock-market correction, muni bonds generate your original yield. However, if an economic slowdown causes the Federal Reserve to reverse course and lower interest rates, the bonds will actually appreciate in value, giving you the option to sell and reinvest in something more interesting. Said another way, they may provide the opportunity to sell high, and buy the stock market when it’s low. Or rates may stay where they are, and you get your tax free 3.125%.

Still not excited? That’s okay; in times of market and economic uncertainty, boring can be a good thing.