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Taxable municipal bonds: recovery gaining steam
- Taxable municipal bonds produced positive performance in the first quarter, despite continued volatility in U.S. Treasury rates and banking turmoil.
- New issue taxable municipal bond continues to be suppressed, providing a technical tailwind supporting performance.
- Municipalities are flush with cash while revenues are setting new highs, making quality credits well positioned for slower economic growth.
Taxable municipal bond market performance improved during the first quarter, as credit spreads narrowed in the face of capital market turmoil surrounding the banking sector. Low new issue supply and declining U.S. Treasury yields led to strong performance. Taxable municipals have positive momentum while offering an attractive entry point to investors. Inflation should continue declining and the U.S. Federal Reserve (Fed) should acknowledge this trend as it prepares to pause. Though the economy may be entering a soft patch, a Fed pause should help bolster strong demand for taxable municipals potentially supporting a rally throughout 2023.
Strong momentum into the second quarter
We see three main factors driving second quarter performance. First, the technical environment is likely to be supportive. Now that we have more clarity from the Fed on the path of interest rates, both investors and issuers may start to move off the sidelines. Muted issuance and strong demand are current tailwinds for the asset class, and demand has been improving year to date. While supply may build throughout the year, it is expected to remain subdued relative to prior years.
Credit conditions are solid, even in the face of interest rate volatility.
Second, credit fundaments remain strong. Municipalities have record levels of tax collections and cash on hand. Credit conditions are solid, even in the face of interest rate volatility. Credit upgrades have been outpacing downgrades by 3.5 to 1, based on full year 2022 data. And as essential service monopolistic providers, municipalities tend to do well in most economic environments.
Finally, long-term valuations are attractive compared to U.S. Treasuries and corporate bonds. Taxable municipal credit spreads could still narrow, creating the potential for additional total return. Along the curve, we continue to look towards striking a balance between yield and duration, identifying mispriced bonds that offer more spread versus similar quality bonds with longer durations. We believe our bottom-up, fundamental credit research is well-positioned to take advantage of the opportunities we are seeing in the market today.
- U.S. inflation has declined sharply in recent months, and the trajectory is favorable.
- Energy prices, housing costs and rents continue to trend lower, which should exert downward pressure on inflation going forward.
- The fed funds rate has risen by 475 bps during this cycle. The market is pricing in one more 25 bps hike for 2023.
- Fed policy remains a function of on employment and inflation data.
- U.S. growth should trend lower as the impact of Fed policy is absorbed. Key factors include interest rate hikes, recent headwinds in the banking sector and declining money supply.
- Recession continues to be a concern.
- Banking concerns are causing rate volatility. Anticipate a return to range bound trading once stable conditions return.
Municipal market environment
- Long-term taxable municipal valuations are attractive on a spread basis, compared to similar maturity U.S. Treasuries and corporate bonds.
- Municipal performance is expected to improve as interest rates stabilize and inflows return.
- Supply remains meaningfully low due to higher interest rates. Net negative tax-exempt supply will likely persist, providing technical support
- Municipal supply will be driven by new issuance for new projects, rather than refunding.
- Demand is returning, attracted by higher yields and potential tax increases.
- Credit remains strong, with historic levels of revenue collections and rainy day funds.
- Attractive spreads plus sound credit conditions offer an appealing entry point. We expect municipal defaults to remain low, rare and idiosyncratic.
Gross Domestic Product: U.S. Department of Commerce. Treasury Yields and municipal credit spreads: Bloomberg (subscription required). Issuance: Seibert Research. Defaults: Municipals Weekly, Bank of America/Merrill Lynch Research. State Revenues: The Nelson A. Rockefeller Institute of Government, State Revenue Report. State Budget Reserves: Pew Charitable Trust. Global Growth: International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD). Standard & Poor’s and Investortools: http://www.invtools.com/. Flow of Funds, The Federal Reserve Board: http://www.federalreserve.gov/releases.pdf. Payroll Data: Bureau of Labor Statistics. Bond Ratings: Standard & Poor’s, Moody’s, Fitch. New Money Project Financing: The Bond Buyer. State revenues: U.S. Census Bureau.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance does not predict or guarantee future results. Investing involves risk; principal loss is possible.
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Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments. This information should not replace an investor’s consultation with a financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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