4 reasons to snap up muni bonds amid flashing recession signals, according to Charles Schwab

While economists remain split on whether the US is rolling toward a recession, at least two notable gauges are flashing clear-cut warnings that a downturn is imminent. For those uncomfortable with this, municipal bonds could offer some relief, Charles Schwab suggested.

The Sahm Rule says the US is in a recession when the three-month moving average in the unemployment average rate moves 0.5% from a 12-month low. This occurred in July.

Another recession indicator is also signaled when the Treasury yield curve re-steepens. This refers to a drop in short-term rates, as has been happening. Yields will fall when investors pile into T-bills, on expectations that a downturn will prompt the Federal Reserve to cut rates.

For its part, Charles Schwab considers it too early to declare an ongoing downturn, but offered a safe-haven tip given elevated risk: municipal bonds.

These fixed-income assets are issued by local governments, cities, and states. Though they don’t offer a high yield, interest garnered from these investments is often free of federal and some state income taxes, Schwab said. Five other reasons make munis worth a glance:

First, muni bonds are often investment-grade assets.

Around seven out of 10 in the Bloomberg Municipal Bond Index are in the top two rungs of credit quality, Schwab cited. When an issuer is rate highly, investors can have more peace of mind knowing that interest payments will be made on time and that default risk is largely non-existent.

In fact, over a 10-year period, only nine out of 10,000 investment-grade munis have defaulted on average, the bank added.

Second, these assets are backed by strong state savings, as local governments typically cannot run a deficit, and revenue must meet expenses. Due to this, rainy-day funds have hit a record high in 38 states last fiscal year, Schwab said, citing Pew Charitable Trusts.

If a recession does start, municipal revenues typically decline later in the cycle.

According to the bank, that’s on account of how a local government is funded: income taxes usually make up the primary source of revenue, and are based on the prior year’s income. Meanwhile, utility service issuers are an essential sector, garnering revenue even in a recession.

Third, recessions rarely result in downgrades for munis. For instance, Schwab noted that muni ratings remained virtually unchanged in September 2008, even as corporate bonds slid.

For investors, that’s an important feature, as it means that muni bonds will maintain their price, Schwab said. Downgraded assets usually depreciate.

Finally, muni bonds posted positive total returns over 12 months at the start of each downturn, Schwab said: of the past five recessions, the 2008 crisis is the only example in which munis underwhelmed.

This occurs because anxious investors are enticed to snap up more risk-free investments, such as bonds.