Taxable municipal bonds: signs of an inflection point

The third quarter began with a false start rally in July, but hawkish U.S. Federal Reserve rhetoric and a disappointing inflation report stifled any comeback. Credit fundamentals are strong and municipal bond valuations are attractive, especially relative to similarly rated corporate bonds. The income generation for investors willing to invest now and wait for a market shift is at the highest level in more than a decade. A slowdown in new issue supply bodes well for a snapback rally in a stabilizing interest rate environment.

Key takeaways:

• With the bad news already priced into municipal bond prices and yields, we see hints of a recovery in demand.
• As demand for municipal bonds strengthens from income oriented investors, supply is falling significantly. Yields indicate that now is a better time to be an investor than a borrower.
• Municipalities in the U.S. are flush with cash while revenues are setting new highs, indicating stable credit quality and positioning them well amid slow growth or a recession.

Outlook: the market may be experiencing a bottom

Investors pursuing a balanced portfolio approach have been frustrated by low fixed income yields in recent years. However, over the first three quarters of 2022, the 10-year U.S. Treasury rate has increased 2.32% to its highest levels since 2010.

Traditional drivers of municipal performance show encouraging signs. Yields are high, credit quality is strong and new issue supply is falling sharply. As a result, technical headwinds during this historic bond market sell-off could quickly reverse into tailwinds supporting a strong recovery. Yield has historically been the best forecaster of long-term municipal bond returns, and this signal seems opportunistic.

The biggest impediment to improved performance remains persistent inflation. Amid the short-term noise, the Fed has completed 300 base points (bps) of tightening and markets have priced in another 150 bps. We may see more cooling of economic and inflation data soon, with the money supply plunging, the dollar skyrocketing and mortgage rates more than doubling.

The extensive economic and market support measures implemented during the pandemic will take time to unwind. We’ve made much more progress than most investors recognize.

While it is difficult to identify the precise peak of interest rates, we are seeing more back and forth inmunicipal bond demand and performance. Municipal bond total returns remained negative in the third quarter as the Bloomberg Taxable Municipal Bond Index returned -6.18%, but more investors are beginning to recognize the opportunity moving forward. And the market environment during July showed how quickly sentiment can improve. With very thin supply, low dealer inventory and attractive yields available in the market, a permanent shift in sentiment could lead to a sharp recovery scenario.

We think all of these factors indicate that the municipal market may be experiencing a bottoming effect.

Municipal market themes for 2022 and 2023

Economic environment

• Inflation remains hard to predict and has likely peaked, but may still be above the Fed’s target.
• Further uncertainty has been posed by geopolitical events.
• Fed funds rate has risen by 300 bps in 2022, with more rate hikes expected.
• Fed’s policy shift is fully discounted by markets.
• U.S. growth is softening due to higher interest rates and fiscal tightening.
• Rates remain volatile, and the path of rates depends on inflation.

Municipal market environment

• Long-term taxable municipal valuations are attractive compared to similarly rated corporate bonds.
• Credit remains strong, with historic levels of revenue collections and rainy day funds.
• Attractive spreads plus sound credit conditions offer appealing entry point ahead of an economic slowdown.
• Defaults remain rare and idiosyncratic.
• Supply is lower than last year due to less taxable municipal issuance from refunding.
• Continued selling from FX hedging costs pressure municipal performance.

Signs of modest cooling in economic growth are developing

The U.S. economy has held up surprisingly well under an array of pressures: Fed policy and fiscal tightening, geopolitical risks and the global slowdown. Ironically, this has prompted the Fed to be even more hawkish in its most recent speeches and forecasts.

We see signs of modest cooling in growth, and these indicators should become more pronounced as the lagged impacts of policy are fully felt. These factors include a decline in net new jobs, a decreasing trajectory of wage gains and surveys such as JOLTS showing a significant decline in unfilled job openings.

The consumer price index dropped significantly in July, both month-over-month and year-over-year. Subsequently, markets were sorely disappointed when the price index ticked back up slightly in August, driven primarily by the stickiness of high rental prices. Fixed income markets remain hyper focused on inflation data, and thus sold off sharply.

Overall, growth and inflation data are declining, but more gradually than investors had hoped. The M2 measure of money supply growth is poised to enter negative territory year-over-year, the federal budget deficit has contracted by more than $3 trillion in just over a year and the U.S. dollar is up by 25% against a basket of other currencies.

Policy changes and back-to-work themes work their way through the economy with uncertain lags. The Fed has been careful not to appear soft on its message of higher rates for longer, nor to shy away from the resulting market volatility.

Alongside other factors, the Fed has significantly lowered the market’s inflation expectations. Perhaps relatedly, we are seeing a more robust discussion of the risks of overtightening and the importance of a pause in the 75 bps-per-meeting trajectory.

The ultimate impact of these major policy shifts remains unknown and should be watched carefully.

Valuations are looking increasingly favorable

U.S. Treasury market yields rose across the curve, but overall the curve flattened during the quarter. The 2-year yield increased 132 bps and the 5-year yield rose 105 bps. On the long end, 10- and 30-year yields increased 82 bps and 59 bps, respectively. Despite this flatness in the treasury curve, the taxable municipal credit spread curve has steepened, offering value for investors willing to ride out volatility.

Treasury yields declined in July, but downside volatility took hold in August and accelerated in September as markets priced in more aggressive Fed rate hikes and a longer period of tighter financial conditions. Toward the end of the quarter, volatility moved in both directions as the market responded to inflation data and foreign central bank policy. On 28 September, the 10-year Treasury yield peaked momentarily at 4.00% before declining to close the quarter at 3.83%.

Taxable municipal credit spreads also fluctuated during the quarter, but remained much higher than the beginning of the year. Spreads for municipals moved in a similar pattern to similarly rated corporate bonds, which also widened during the same time period. However, as risk of recession increased in August and September, corporate bond credit spreads became more volatile than taxable municipal spreads.

Average option adjusted spreads for the Bloomberg Taxable Municipal Index began the quarter at 111 bps and ended at 119 bps, with credit spreads peaking in mid-August at 125 bps. We note that the longer end of the curve witnessed much greater spread widening, with option adjusted spreads for 30-year taxable municipals reaching 179 bps, the highest level for long-dated taxable municipal bonds year-to-date.

The trend of greater spread widening on the long end of the curve is most likely related to differing pockets of demand. Rate volatility has caused weaker total returns for longer duration bonds. However, we expect investors with long-term horizons will begin slowly adding to their long duration exposures at these valuations. Indeed, during the latter part of the quarter, as all-in yields moved comfortably over 5% for AA-rated taxable municipals, life insurance companies and pension funds began to add longer duration exposure.

Although rate volatility is inevitable, we anticipate a better balance going forward. The Fed’s tone has certainly been hawkish, upping its forecast for the peak in the fed funds rate to 4.6% next year. Investors can be encouraged that the futures markets and the Treasury yield curve have priced in this new guidance.

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