Taxable municipal bonds: headwinds of 2022 could be tailwinds of 2023

Key takeaways

• Municipal bonds produced positive performance in the fourth quarter, despite continued volatility in U.S. Treasury rates and stubbornly wide credit spreads.
• New issue taxable municipal bond supply fell sharply during the fourth quarter and in 2022. Yields indicate that now is a better time to be a bond investor than a borrower.
• 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 remained volatile during the fourth quarter as credit spreads peaked to their year-to-date highs during October. Nevertheless, low new issue supply and a more rangebound U.S. Treasury yield environment led to improved performance. Municipals ended the year with positive fourth quarter returns. Looking ahead, inflation should continue declining and the U.S. Federal Reserve should acknowledge this trend. In this case, the macro tailwind should help bolster strong demand for taxable municipals and contribute to a rally in 2023.

Outlook

A positive fourth quarter creates momentum heading into 2023

Macroeconomic factors came more into balance late in 2022. For example, while 12-month trailing inflation remains very high, the last five months’ trajectory is in line with the U.S. Federal Reserve’s (Fed) target. The Fed remains determined to fight inflation, but we have seen a subtle shift in its hawkish tone and a decelerating pace of rate hikes.

Supply chain problems have eased significantly. And while the labor market remains strong, people going back to work is ultimately positive for the economy. Average hourly earnings growth has slowed with rising participation in the labor market.

However, U.S. Treasury rates rose only slightly in the fourth quarter, a marked contrast to the first three quarters.

This more balanced interest rate picture fueled positive performance during the fourth quarter. The positive returns can be further boosted as credit spreads begin to narrow amid improving sentiment and strengthening investor demand.

This resilience in the face of a volatile macro environment and Fed tightening offers several reasons for optimism in 2023. Taxable municipal returns have historically bounced back strongly the year after a year of negative returns. This trend is supported by higher yields that attract new capital to the market. While economic and Fed policy uncertainty will likely lead to more periods of U.S. Treasury rate volatility in 2023, taxable municipals are cushioned by much higher yields.

Traditional municipal bond factors took a back seat to Fed policy in 2022, but these elements look favorable overall heading into 2023. Upgrades outpacing downgrades in the face of high inflation underscore the monopolistic presence of municipal issuers and the essential services they provide. And the low supply of taxable municipal bonds together with strong credit fundamentals position the asset class well for a possible recession. We believe a less active Fed should pave the way for these municipal factors to create a market recovery this year.

Municipal market themes for 2023

Economic environment

• Inflation remains hard to predict and has likely peaked, but will remain above the Fed’s target for 2023.
• Further uncertainty has been posed by geopolitical events.
• The Fed funds rate rose by 425 bps in 2022, with more rate hikes expected during the first half of 2023.
• The Fed’s policy shift is fully discounted by markets.
• U.S. growth is softening due to higher interest rates and fiscal tightening.
• We believe peak interest rate volatility is in the past; we expect a more contained rate environment going forward.

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, being confined to high-risk sectors.
• After tepid supply in 2022, we expect new issuance to regain momentum in 2023. When U.S. interest rates and the U.S. dollar stabilize, demand should strengthen.