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Municipal Bonds

Taxable municipal bonds: signs of an inflection point

Daniel J. Close
Head of Taxable Municipals
John V. Miller
Head of Municipals
Taxable municipal bonds

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:

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

Municipal market environment

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.

For more information, please visit nuveen.com.

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Endnotes

Sources

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.

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her financial professionals.

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.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

Important information on risk

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.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

Nuveen provides investment advisory solutions through its investment specialists.

This information does not constitute investment research as defined under MiFID.

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