Municipal bonds: an attractive entry point

Municipal bonds have had a rocky start to 2022, but credit quality remains strong. With aggressive rate increases and a shrinking balance sheet, the U.S. Federal Reserve is signaling a quicker move toward a neutral policy rate. Markets are already pricing in these rate hikes, and Fed balance sheet runoff has historically led to flatter yield curves. We believe today’s attractive municipal bond valuations and higher yields, combined with strong credit fundamentals, bode well for longer-term performance.

What actions is the Fed taking?

As expected, the Fed raised the fed funds rate by 25 basis points (bps) in March and another 50 bps in May, the first 50 bps hike in more than 20 years. We expect two more 50 bps increases at the June and July FOMC meetings, followed by three more 25 bps hikes. This may change if the economy begins to slow and inflation recedes faster than expected. In addition, Fed balance sheet assets will roll off — up to $95 billion per month — as the Fed continues to focus on normalizing monetary policy.

Futures markets and short-term interest rates already incorporate these rate hikes, including even more near-term hikes than the Fed’s latest projections. Historically, the yield curve has flattened during periods of balance sheet runoff, and the level of long-term yields ultimately fell after an initial increase. These trends often signal a stabilization in interest rates, as increased demand for longer-term debt means investors believe that today’s adjusted levels may represent a peak.

How has the municipal bond market reacted?

U.S. Treasury yields may be settling into a new range, but the municipal bond market has remained unsettled and more volatile. In light of this, municipal-to-Treasury yield ratios have risen sharply, with 30-year ratios hovering around 110% as of 20 May. This indicates municipals are underperforming Treasuries. In fact, looking back to 2006, 30-year municipal-to-Treasury ratios have only been above these current valuations 13% of the time. Non-traditional buyers, or those investors who do not benefit from the tax-exempt nature of municipals, find these yield levels are offering compelling relative and absolute value.

Municipals ended 2021 relatively rich by historical standards, and many of the driving factors remain: strong credit trends, moderate bond supply, significant roll-off of municipal bonds and tax rates more likely to rise than fall. However, in 2022, municipals have been even more sensitive to two factors that have changed significantly: interest rates and fund flows.

Municipal yields for 10-year AAA bonds have more than doubled from one year ago, as of 30 April. Demand for tax-exempt yield was extremely strong just a few months ago at far lower yields, and we think this demand will resurface. Given municipal bonds’ over-the-counter nature and the consistent rise in rates year-to-date, significant mark to market losses have occurred this year. As a result, some of the best segments of credit, with some of the most liquid bonds, have underperformed due to market liquidity needs.

The municipal bond market has struggled with historically high fund outflows, at nearly $54 billion year-to-date as of 30 April, along with substantial new issue supply (Figure 1). Fund outflows have been the primary reason for cheaper municipal bond valuations.

Credit quality remains strong, with positive economic growth boosting tax revenues for municipalities to all-time highs. Rainy day funds and pension funding are at the healthiest levels in decades. State government tax revenue collections increased 22% in 2021 compared with 2020, which is 20% above the pre-pandemic level in 2019. Most sectors have a stable or positive rating outlook, according to Moody’s. In 2021, Moody’s issued more upgrades than downgrades, with 817 upgrades and 307 downgrades (Figure 2).

The need for liquidity to support outflows has put significant pressure on more liquid names. Notably, high yield credit spreads remain stable, moving only a modest 32 bps since the beginning of the year through 20 May. Underlying credit fundamentals remain stable or stronger, which presents significant opportunity as market stability returns.

Where do we go from here?

Over the last 20 years, municipal bond interest rates rising by more than 100 bps in a short time period has created a favorable entry point for investors. During these significant market events, heavy outflows further cheapened the asset class on a relative basis, notwithstanding strong fundamentals.

Today, in the investment grade universe, we emphasize market segments like toll roads, hospitals and airports that are often rated in the single-A range. Those 4% coupons are currently yielding as much as 4.5% (at a discount to par), a level that would have been unattainable just a few months ago. In high yield, we particularly favor shorter-duration high yield municipals, which are experiencing improving credit quality and have been relatively insulated from interest rate volatility.

Additionally, some of the most liquid and well-known high yield bonds are down substantially from their highs. Many of the fundamentally stronger and more stable high yield credits, such as those backed by rising sales and property tax revenues, along with essential infrastructure projects, have declined more than market indexes. While this seems counterintuitive, we believe the recent need for liquidity has impacted these relatively stronger high yield names. This dynamic presents an opportunity when technical conditions improve.

Further, outsized reinvestment money is expected in the next few months that should keep municipal bonds well bid — $44 billion on 01 June and $48 billion on 01 July. The key question facing fixed income investors in the near term is when rates will begin to stabilize, thereby instilling greater confidence that it is a favorable time to invest.

For those with a long-term fundamental view and cash on hand, this may be an attractive entry point for municipal credit risk. Net negative municipal new issue bond supply should provide technical support to a market well-positioned to recover due to high yields, strong fundamentals and historically attractive relative value positioning.