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Municipal Bonds
Taxable municipal 2023 outlook: still cloudy but brighter days ahead
Key takeaways
- The Federal Reserve will accomplish its goal of bringing down inflation, pausing the rate hike cycle by mid-2023.
- Taxable municipal bond yields and yield spreads are attractive, which will garner demand as the interest rate environment stabilizes.
- Taxable municipal credit strength will shine in 2023. As recession risks weigh on more credit sensitive asset classes, municipals should remain resilient.
2022 was sobering for taxable municipal bonds, with the market plagued by surging interest rates, pessimistic market sentiment and the glimmer of rebounds quashed by U.S. Federal Reserve rhetoric.
Despite poor market performance, however, the underlying strengths of taxable municipal bonds have persisted. State government revenues and reserve funds remain strong, and investor demand is showing signs of outweighing supply. The year may have been tough, but conditions may be poised for improving market sentiment in 2023.
The end of the Federal Reserve's rate hiking program is within sight
All eyes will remain on the U.S. Federal Reserve (Fed) in 2023. The Fed funds rate has increased 375 basis points (bps) this year and we expect another 150 bps of hikes (+50bps in December 2022, +100bps in 2023), ending at a 5.25% terminal rate. Inflation will likely remain above the Fed’s 2% target over the course of next year, but there is growing evidence that it has peaked. We expect inflation will continue to soften, driven by declining energy prices and eventually by the stickier parts of inflation like lower housing costs and rents.
Once the Fed reaches its terminal rate, assuming inflation comes down, the Fed should be on hold for the balance of 2023. Current Fed funds futures estimate the Fed to begin cutting in 3Q23 because the risks of recession will be too hard to ignore. The expectations of an economic slowdown and potential pressure on the Fed to turn more dovish will keep interest rates contained on the long end of the yield curve, creating a more constructive environment for fixed income investors.
The odds of recession are increasing. We believe there is a greater likelihood of a recession in late 2023 as lagged impacts of Fed rate hikes are yet to be realized. An economic slowdown can push long rates lower, supporting high-quality, long-duration fixed income returns. The positive news is the Fed now acknowledges these recession risks exist. This acknowledgement, combined with the growing evidence of peaked inflation, supports the argument that the Fed will pause rate hikes by late 2023.
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Endnotes
Sources
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.
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Important information on riskInvesting 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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