Americans' growing wealth points to a boom in a tax-exempt corner of the bond market

• Municipal bonds could see a boost from the growing ranks of wealthy Americans. 
• According to Western Asset Management, tax-exempt muni bonds are a hot target. 
• Adjusted gross income in the US spiked 17.7% to $2.2 trillion in the 2021 tax year. 

Americans' wealth is growing, and with it, so could their demand for investments that can protect some of that wealth from taxes. 

The market for municipal bonds — debt issued by local and state governments to fund projects that generate yields that are exempt from federal taxes — should be a hot target for the growing ranks of the wealthy, according to a note from Western Asset Management. 

Adjusted-gross-income in the US spiked 17.7% to $2.2 trillion in 2021 tax year, the highest year-over-year surge in two decades, following the continued recovery from the pandemic and a stronger labor market, according to an analysis from Western Asset this week based on recent IRS data. 

Growing net worth makes muni bonds more attractive as a tax shield, especially as investors anticipate the first rate cut on the horizon from the Federal Reserve, which would push bond values up. 

"Wealth levels are a key driver of taxing power for state and local governments, and this IRS release is an example of recent strength that has supported recent record high tax collections and favorable municipal credit quality," Western Asset's Samuel Weitzman wrote in the note. 

"From a market technicals perspective, income trends also inform the composition of potential demand for municipal securities, not only shedding light on the number of taxpayers that can benefit from the municipal tax exemption, but also in which states demand could be highest."

By state, Wyoming led the wealth gains in the US in 2021 with a 27% increase in adjusted gross income, followed by Nevada which saw a 26% surge, and Montana with a 22% jump.

The muni market saw a $10 billion surge in new issues last week, a 10% jump from the previous week. Similar to fund flows, municipal mutual funds logged $295 million in net inflows by March 16, as per Lipper data.

Goldman Sachs previously wrote earlier this year that investors could grab cheaper muni bonds amid high yields before the central bank slashed rates, potentially lowering yields.

"Investors have had the opportunity to lock in yields that we have not seen in a very long time. Yields will fall in 2024 and quality bonds will perform," said Sylvia Yeh, the Goldman Sachs' co-head of municipal fixed income. 

The Fed kept the interest rate unchanged at the conclusion of its meeting on Wednesday, but its "dot plot" reiterated that it sees three rate cuts coming in 2024.