Making the case for municipal bonds despite recent volatility

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After a rocky start to the year in US municipal bonds, investors have not seen a reprieve as the second quarter of the calendar year started off with more of the same volatility. Yields have continued to move higher, roughly 166 basis points (bps) from the start of the year.¹ This has caused much of the downward price pressure on the sector and is being exacerbated by heavy outflows from retail investors.

The municipal market will continue to be pressured by the Federal Reserve’s (Fed’s) monetary policy that is aimed at helping to stem inflation as well as those inflationary pressures continuing to drive longer-term yields higher. As we have previously highlighted when providing updates on the municipal market, we will provide outlook for three important dynamics across the sector: technicals, fundamentals and valuations.

Technicals

Technicals show no sign of changing course in the short term after 15 straight weeks of muni outflows.²

• We believe muni-market volatility will remain elevated with continued monetary policy tightening, even with the 50 bp rate hike at the May Fed meeting. If yields stabilize, the lower volatility could potentially support the municipal market.
• As noted below, investors are beginning to take notice of the attractive valuations and tax-free income potential. We just haven’t seen that en masse to this point.
• A tightening of new issuance in the upcoming weeks will likely help to slow down the supply/demand imbalance created in the most recent quarter. In our view, the summer reinvestment period may help offset outflows as money will likely need to be put to work in the market.

Fundamentals

According to our analysis, fundamentals continue to provide a strong backdrop for sustained recovery.

• Fiscal policy: Most states will finalize their fiscal year (FY) 2023 budgets this quarter. We expect to see strong results posted for FY22 in part because of growth in sales taxes and income taxes due to strong employment dynamics. We continue to monitor how states are allocating the surpluses that have been collected over the past year. We believe the more prudent route would be for those states to provide funding for projects that require one-time use of capital rather than programs that will continue to require an allocation of capital year over year. To that end, our initial observations show that prudency is prevailing in the budget process, which is a positive sign, along with record surpluses in several areas.
• Ratings actions: We continued to see the trend of upgrades coming from the various rating agencies. Illinois and New Jersey both enjoyed an upgrade in the credit quality as a result of current surpluses and improved paths. As it currently stands, there were 2.7 credit upgrades in 2021 for every one downgrade.³
• Economic indicators: All eyes will be on inflation and the Fed to see how that impacts growth and the yield curve. A lot has already been priced into the market at these levels.

Valuations

Valuations for AAA munis look more attractive than their US Treasury (UST) counterparts, on a nominal basis. We would normally expect a ratio of below 100% due to the tax-exempt nature of munis and we are above that level.

• The 30-year muni/UST ratio continues to remain elevated (above 100% in the start of May), signaling relative cheapness to that of maturity-equivalent Treasuries.
• The 10-year muni/UST ratio has also moved meaningfully higher and recently crossed 100% as well, which is a level we haven’t seen outside of the COVID-19 period since late 2016.⁴
• The taxable equivalent yields that muni bonds are producing may allow buyers to take advantage of the attractive yield levels on an after-tax basis. When you compare these levels to other areas of fixed income there are few areas that are higher, especially when you adjust for credit quality differences. This may provide many investors an attractive entry point to earn a more attractive level of tax-free income.

Given the macro environment consisting of inflation, higher yields and lower prices, investors have been quick to reduce their allocation to municipal bonds. This has put a tremendous amount of technical pressure on the sector. In typical fashion, our team of portfolio managers and analysts has been selectively targeting opportunities we find attractive relative to the overall market. With the strong rise in yields, securities across maturity terms and credit quality have presented buying opportunities.

While current holders of the asset class are disappointed with the price volatility, we believe their patience will be rewarded with a market that will present potentially higher yields. They should also take solace in the fact that since 1980, the municipal bond market has never suffered two consecutive years of negative performance.⁵ When you compare the current valuations and fundamental strength, we believe the muni asset class provides a very attractive investment opportunity for investors.

What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the portfolio’s value may decline. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.

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1. Source: Bloomberg, January 3, 2022 – April 29, 2022. BVAL Municipal AAA Yield Curve (Callable) 10-year, CAA 10YR BVLI Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

2. Source: Bloomberg, January 3, 2022 – April 29, 2022.  ICI Municipal Bond Long-Term Mutual Fund and ETFs Weekly Flows, WETFMBLT Index.

3.  Source: Moody’s, as of December 31, 2021.

4. Source: Bloomberg Barclays, as of April 29, 2022.

5. Source: Bloomberg; Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.