Turn to this high-quality income play for the new year, Wells Fargo Investment Institute says

Investors who hope to generate portfolio income while recession fears ramp higher can seek some safety in municipal bonds. Wells Fargo Investment Institute recently issued its fixed income guidance for 2024, forecasting “higher for longer” rates across the yield curve as the Federal Reserve remains vigilant to bring down inflation. The bank also upgraded state and local general obligation bonds to favorable from neutral, highlighting issues rated double-A by agencies such as Standard & Poor's and Moody's. “Given what are generally broad and diverse economies, combined with significant tax-raising and expense management capabilities, individual states have historically shown significant resilience when it comes to credit quality, even during times of recession and economic uncertainty,” Wells Fargo Investment Institute said in its Nov. 15 report. Municipal bonds offer a combination of characteristics that appeal to investors: General obligation bonds are backed by the revenue of the municipality issuing them. They spin out income that's free of federal taxes – as well as state levies if you live where the bond is issued. Finally, thanks to the Fed's round of rate hikes, yields on AAA munis can be as high as 5% on a tax equivalent basis. This year, investors poured $4.5 billion into the iShares National Muni Bond ETF (MUB) and directed more than $6 billion in new money into the Vanguard Tax-Exempt Bond ETF (VTEB) , according to FactSet. A prime time to get in One reason now might be a good time to snap up municipal bonds is because of the outlook in the new year. Though the Fed gave no indication of potential rate cuts at its latest meeting, fed fund futures pricing suggests a chance that policymakers could start to trim rates in the spring. “Going into a slowdown, you anticipate rates to fall,” said Brian Rehling, head of global fixed income strategy at Wells Fargo Investment Institute. “Muni bonds tend to have longer maturities and perform well when rates fall.” Bond prices move inversely to their yields. When interest rates fall, prices rise — and longer-dated issues have greater price sensitivity to fluctuations in rates. While investors have crowded into cash-like investments such as Treasury bills and money market funds thanks to higher yields, they will have fewer options for reinvesting when rates fall; municipal bonds can be a good alternative for investors who are willing to lock in higher yields for a longer period. “Now is the time to go out longer and take away the concerns of reinvestment risk,” said Jennifer Johnston, director of municipal bond research for Franklin Templeton. She noted that tax equivalent yield is another consideration when looking at municipal bonds. Munis offer less yield than their taxable counterparts, but to compare the two, investors must think about the tax-equivalent yield – that is, the return you'd have to get from a taxable bond to equal the tax-exempt yield on a muni bond. A taxpayer who is in the 32% federal income tax bracket would have to find a taxable bond yielding 5.15% in order to equal a tax-free yield of 3.5%, according to an analysis from New York Life Investments . Investors residing in high tax states can save even more by shopping locally for munis. The top marginal income tax rate is 13.3% in California and well over 10% in New York and New Jersey. Finding sectors that can handle a slowdown Johnston said that she has been focused on credits that have benefited from inflation, keeping an eye out for state and local governments that can manage a slowdown. In particular, she likes housing bonds. “One of the drivers of inflation is the cost of rent, so that means more reserves to housing authorities, be it workforce housing or essential housing,” she said. States can also issue bonds to invest in affordable housing. Johnston is less upbeat about private higher education, which she says faces challenging demographics and a lot of merger and closure activity. Bonds related to mass transit are also on her radar as costs rise and ridership suffers. “New York State has offered good funding to the [Metropolitan Transportation Authority], but does that continue?” she asked. “What happens when revenues at the state level grow a little more slowly and there isn't as much revenue to go around?”