The Institute gathered Jennifer Johnston, Director of Municipal Bond Research, Franklin Templeton and Robert E. Amodeo, CFA, Head of Municipals, Western Asset Management, to discuss opportunities and concerns across municipal bonds.
Below are my key takeaways from our discussion:
Municipal bonds are displaying unusually strong fundamentals. The backdrop of local fiscal conditions is solid, contributing to the strength of muni bonds in the current environment. State and local governments have been able to replenish cash reserves as a result of three things: large capital inflows from the Federal level throughout the pandemic, tax receipts that have exceeded pre-pandemic levels and moderate spending. There has been less municipal bond issuance compared to the pre-pandemic period, creating a scarcity of muni bonds.
Some unexpected areas are creating headwinds for muni bond valuations:
- Commercial real estate. The shift to more remote work has impacted the office space sector and the businesses that support office spaces in downtown areas. This has led to lower assessed valuations, producing less property taxes. It is also felt in less transit use and funding. Other businesses in office areas may close, thus reducing tax revenues.
- Labor market. The strong labor market is a headwind in muni markets as it has created difficulty for states and municipalities to hire. Specifically, it has been difficult to hire nurses in health care and senior living settings, causing those organizations to rely on more expensive contract and travel nurses. It has also been difficult to hire some government administration roles with shortages of auditors leading to delayed financial reporting in some states.
- Inflation. Rising costs eat into operating costs and margins. On the capital side, costs increases are making projects and project financing more expensive. There is some benefit that comes from inflation for municipalities—as goods, sale prices and wages increase, so do the tax revenues for the locality.
There are different offerings across different coupon levels. It may be that a project has multiple muni bonds issued with differing coupons (interest rates) and very similar investment features. This could produce sizable income differences for an investor. It is important to evaluate the total return of a muni bond, identifying the coupon, but also the anticipated bond value and any tax penalties.
It’s not too late to take advantage of the investment opportunity. There are still opportunities in munis even as rates have climbed and credit spreads have widened since last fall. These opportunities require careful analysis to identify the underlying value of the investment and the structural features of the offering.
Individual investors have many reasons to consider increasing muni exposure in their portfolio. For taxable assets, the after-tax return is particularly attractive relative to other fixed income investment choices. It may make sense to move from cash to well-researched muni bonds at this time. Munis in the five-year to 20-year range are particularly attractive, in our opinion. With careful analysis, an investor can create a better mix of credits than in corporate bonds. And the historic default rate of munis has been lower than corporates.1
Show caution in certain sectors. The strong labor market is having an impact on operating margins in health care and especially senior living. Mass transit has not fully recovered due to a shift to working from home so research is necessary to ensure that revenue is diverse enough to weather the changes in ridership. Also, rider fares do not back all mass transit bonds; sales taxes, state aid or payroll mobility taxes back some of them. The other sector where caution is warranted is small, private liberal arts colleges. The combined effect of a smaller number of graduating students going to college and COVID have impacted these colleges. An unprecedented number of small, private colleges have closed in New England, in particular.
The regional banking crisis has had minimal impact on the overall muni market. Regional banks hold about 15% of all muni bonds. At this time, holdings from Silicon Valley Bank (SVB) and Signature Bank are being sold out of the banks’ holdings as part of their restructuring. Bonds were purchased in the secondary market without a noticeable price impact. It is not clear if regional banks will consistently hold the same allocation to munis in the future and if this will have an impact on the market.
What is clear is that despite uncertainty in the macro outlook, we believe municipal bonds are very attractive investments, especially on an after-tax basis. Investors need to conduct detailed analysis to identify the right sector, coupon, maturity and other characteristics to find the best opportunities.
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.
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.
Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
__________
1. Source: ICE BofA Indexes, as of May 2023.
