Are we in a recession? That's a question only the National Bureau of Economic Research (NBER), the official arbiter of recessions, can answer. However, investor concern has risen.

There have been two notable signals that the economy may be on the cusp of a recession:

• the re-steepening of the yield curve, which historically steepens prior to the onset of a recession, led by falling short-term rates as the Federal Reserve cuts rates in an attempt to spur the economy.
• and the triggering of the "Sahm rule," created by economist Claudia Sahm, which states that when the three-month average of the U.S. unemployment rate rises by at least a half-percentage point above its low during the previous 12 months, the economy is likely in recession. The Sahm rule was triggered by the July U.S. jobs report.

Although there are signs that are flashing recession, we think it's too early to declare that the economy is in a recession. However, the risk is elevated and for investors who are concerned about a recession, municipal bonds may provide some shelter.

Municipal bonds are bonds that are issued by cities, states, and local governments and often pay interest payments that are exempt from federal and potentially state income taxes. They usually have lower yields than bonds like Treasuries or corporate bonds, all else being equal, to account for the tax benefits. As a result of the tax benefits that munis offer, they can be an attractive conservative investment option for investors in higher tax brackets.

Here are five reasons why we believe that munis may provide some shelter if a recession hits.

1. Most are very high credit quality to begin with, which can buffer the impact of a recession. On average, most states and local governments have strong finances and stable revenues. This is reflected in a high credit rating. Roughly seven out of 10 bonds in the Bloomberg Municipal Bond Index, a broad index of munis, are rated either AAA/Aaa or AA/Aa, which are the top two rungs of credit quality.¹ Higher-rated issuers, on average are less likely to miss a scheduled interest or principal payment. This differs from other fixed income markets like the corporate bond market where most corporate bonds in the index are either A/A or BBB/Baa rated.

Municipal bonds historically have been very highly rated but recently the average credit quality of the market has improved. The proportion of AAA/Aaa or AA/Aa munis in the index was roughly 62% in 2013 but has since climbed to 71.4%—which is the highest proportion since the 2007-2008 credit crisis. The high average credit quality historically has led to very few defaults in the muni market. In fact, on average, only nine out of 10,000 investment-grade munis defaulted per year over a 10-year period.²

2. States have been building up their savings, which they can tap into if there's a slowdown in revenues. Most states have a rainy-day fund, which is akin to a savings account, that they can tap into if necessary. Almost all states operate with a balanced-budget requirement, which means that annually, they have to ensure that revenues meet expenses. This is unlike the federal government, which can run a deficit. If revenues aren't enough to meet expenses, states either have to cut expenses, raise revenues like taxes, tap into their rainy-day funds, or take other budgetary measures.

Over the past few years, most states have built up their rainy day funds. Rainy-day funds reached a record high in 38 states at the end of fiscal year 2023, according to The Pew Charitable Trusts. In fact, Pew estimates that the average state could operate for roughly a month and a half on savings alone. Pew also estimates that 19 states reached a record of the number of days they could operate on savings alone largely due to tightening spending.

3. Revenues historically have declined later after a recession starts. Many municipalities have revenue sources that lag or are mostly isolated from economic activity. For example, the bedrock of local governments' finances are typically property revenues. Taxes are usually based on the assessed value of the property which typically lags the market value. Additionally, most states rely on income taxes as their primary source of revenue, which are often based on the prior year's incomes. Finally, some issuers, like water utility districts, have revenues that are essential services. Even if a recession hits, it's likely that most property owners will prioritize paying their water bill over other expenses.

Because of the way most state and local governments' revenues are constructed, it has resulted in tax revenues declining usually long after the recession has already started. For example, tax revenues held up during the first few years of the 2007-2008 recession. Revenues didn't start substantially declining until 2010. This long lead time gives state and local governments ample planning time to adjust expenses.

4. Ratings have been stable in past recessions. As a result of generally stable revenue sources and other factors, munis tend to be downgraded less frequently than corporate bonds, which tend to have more volatile revenue streams. This is especially true when a recession occurs.

As illustrated in the chart below, ratings drift is much more volatile for corporate bonds compared to munis. Ratings drift is the average change in credit-rating "notches" for every 100 bonds over the observed one-year period. One "notch," for example, is the incremental difference between AA+ and AA. In other words, in September 2008, the average corporate bond was downgraded 0.7 notches while the average municipal bond's rating was essentially unchanged. This is important because when a bond is downgraded or the market anticipates it may be downgraded, it usually falls in price.

5. Performance is generally positive following the onset of a recession. Longer-term bonds tend to track the direction of inflation and the economy. A recession, by definition, is a sustained period of economic decline, which historically has translated to yields for longer-term bonds falling. In four of the past five recessions, municipal bonds have posted positive total returns over the 12 months following the start of the recession. Only in the 2007-2009 recession did munis post a negative return in the 12 months after the start of the recession.

Munis posted positive total returns during the 1990 and 2001 recessions because yields were already moving lower and continued to move lower as investors sought less-volatile investments, like bonds. The 1981 and 2020 recessions were relatively unique. The 1981 recession was characterized by the Federal Reserve aggressively hiking interest rates to squash record-high inflation. The 1981 recession officially started in July of that year when the yield on a broad index of munis was 11.4%. The very high starting yield translated to a very strong performance in that period. The 2020 recession was unique in the sense that at no other time in modern history has a global pandemic caused the entire U.S. economy to come to a screeching halt. It's worth noting that each economic slowdown is unique, and history may not repeat itself when the next recession occurs.

Historically, municipal bonds have been a respite from an economic slowdown. The long lead time between the start of a recession and revenues slowing gives issuers ample opportunity to prepare. This has resulted in fewer ratings changes and defaults relative to corporate bonds. For help selecting the right investment options given your situation, reach out to your Schwab representative.