Taxable municipal bonds: Late second quarter trends bode well for a rebound

Key takeaways

• With negative news already priced into taxable municipal bond prices and yields, we see hints of a recovery in demand.
• Higher rates and persistent inflation continued to pressure fixed income and municipal market performance.
• Municipalities are flush with cash, making them well-positioned for slow growth or a mild recession.
• Toll roads have been among the quickest to recover from pandemic lows, returning close to activity seen prior to COVID.

The taxable municipal bond market continued to struggle during the second quarter, down -6.20% for the quarter. Headwinds included volatile U.S. Treasury rates, persistent inflation and rapid U.S. Federal Reserve policy tightening. But positive developments also emerged late in the quarter. Some economic data pointed to a less overheated economy. Following the worst six-month period of taxable municipal market returns in history, relative value and absolute yields began attracting long-term buyers creating pockets of strong relative performance.

Outlook

Higher yields and attractive valuations offer opportunity

Investors are increasingly worried that the Fed might have to force the economy into a recession in an effort to return the U.S. to price stability. We believe a soft landing is still most likely, but expect real GDP growth to hover around 0%. Municipal credit fundamentals have continued to show record strength, which should support the value of the asset class in a weak or slow growth economic scenario.

We believe several trends bode well for a potential rebound in the taxable municipal bond market. With additional rate increases already priced into fixed income markets, longer-term Treasuries and longer-term inflation expectations hint at a more stable trading range as of the end of the second quarter. Given the relative cheapness of the municipal asset class, this rate stability could easily support the emerging pickup in demand for municipal bonds, leading to improved performance during the second half of the year.

Fiscal and monetary tightening are moving at an historic pace, and we are starting to feel the impact. The U.S. dollar is strengthening versus the euro and the yen, and we are seeing resulting pullbacks in some commodity markets. Mortgage rates have nearly doubled in six months, cooling the super-tight housing markets. While lags in timing are inherently unpredictable, these factors should filter through to inflation statistics during the second half of the year.

Meanwhile, taxable municipal bond returns have most likely endured the worst of the pain for the year, and valuations look attractive. Yields increased by nearly +200 basis points (bps) for the Bloomberg Taxable Municipal Index on a year-to-date basis. Historically, yields have historically been the best predictor of forward-looking returns, and they now appear high enough to account for an aggressive Federal Reserve while generating renewed enthusiasm for investing in bonds.

During the month of June, we saw positive performance for long duration taxable municipals, with bonds of 15 years of duration or longer returning +0.37% within the Bloomberg Taxable Municipal Index. This performance profile is displaying strong demand from long-term buy-and-hold investors. If this trend continues, it is a strong signal that the municipal market could see positive returns for the second half of the year.

Themes

Taxable municipal market themes

• The level of inflation remains hard to predict. While we believe inflation has peaked, the incremental price declines indicate inflation is still above the Fed’s target. Geopolitical events are creating further uncertainty.
• The Fed has raised interest rates 150 bps so far in 2022, with more hikes expected through this cycle. The Fed’s policy shift has been fully discounted by the markets.
• Peak economic expansion is behind us. Economic growth is beginning to soften due to higher interest rates and fiscal tightening.
• Interest rate volatility is now moving in both directions. The path of interest rates depends on how inflation evolves.
• Credit fundamentals remain strong, with revenue collections and rainy day funds at the highest levels in history.
• Taxable municipal supply is lower year over year, due to fewer refunding deals.
• Consumer behavior has normalized and returned to pre-pandemic trends.
• Market dislocation has created an attractive entry point for long-term investors in all areas of the municipal market.

Inflation continues to drive market volatility

The inflation outlook remains the key driver of fixed income performance and volatility. On this front, overall municipal market conditions in the second quarter looked a lot like first quarter. The taxable municipal market showed signs of a potential rally in late May as U.S. Treasury yields shows some stabilization. But this stability proved short lived once the inflation reports for May indicated that the peak inflation dynamic might look like a plateau.

The Fed stated it needs to see “clear and convincing evidence” that inflation is trending downward before changing policy. We may be seeing signs of this shift, and a number of positive developments should bode well for second half performance.

Rapidly increasing mortgage rates signal a cooling of home price appreciation. Key commodity prices declined over in June, as investors began to worry about the impact of fiscal and monetary tightening on consumer spending.

U.S. dollar strength should help put downward pressure on inflation. The U.S. Federal Reserve has acted fast and is indicating greater interest rate moves than other global central banks. As a result, the U.S. dollar appreciated by 18% versus the yen in the first half of 2022 and is up 12% versus the euro, and it is expected to soon reach parity.

While the June employment report indicated that the labor market remains solid, average hourly earnings growth decelerated and layoffs and hiring freeze announcements are slightly higher.

All of these factors helped reduce longer-term inflation expectations by more than 100 bps over the last month, establishing the recent trading range for the 10-year Treasury bond between 2.80% and 3.30%.

The taxable municipal bond market maintained a fragile tone throughout the first half of 2022. Uncertainty remained high around where the fed funds rate would peak, the top level of inflation, how fast inflation may fall and the appropriate level for the 10-year Treasury bond yield. Re-assessing these issues contributed to taxable municipal market volatility and credit spread widening. Therefore, the ability to establish this new trading range during this cycle should improve confidence and stability.

The Fed is frontloading rate adjustments

In this mid-term election year, the Fed is under intense political pressure to rein in inflation. The central bank has been playing catch up in 2022, tightening faster than in most past cycles. The June hike of 75 bps brought the year-to-date increase to 150 bps, with an additional 75 bps increase in July. The Fed has not hiked rates by 75 bps multiple times in the same tightening cycle in nearly 40 years.

While the speed of this tightening has driven negative total returns for municipals year to date, we are starting to see positive signals. Forward looking inflation expectations show the CPI falling into the mid 2% range over the next few years. In addition, futures markets indicate that the Fed will start cutting interest rates by the second quarter of 2023. That means longer-term bond yields might have seen their highs for this cycle.

Historically, a taxable municipal bond market selloff of this magnitude has been followed by a rally strong enough for investors to recoup losses over the next 12 months simply by remaining invested. This pattern has held over the past six such cycles. If U.S. Treasury rates are at or near their inflection point for this cycle, we believe this historical trend could still hold, indicating attractive returns over the coming year.

Valuations continue to support taxable municipals

U.S. Treasury market toggled between fears of inflation and recession. The 10-year U.S. Treasury yield started the quarter at 2.39%, peaked at 3.47% and dropped back to 3.02% to close the quarter.

The Bloomberg Taxable Municipal Index returned -6.20% during the second quarter. Credit spread widening occurred but was uneven across credit quality. Oddly, AAA-rated taxable municipal bonds experienced more spread widening (+20.7bps) then the overall market (+15.8bps) for the quarter. These credit spread movements indicated that technical conditions were the predominant force in spread widening, as opposed to fundamental factors which remain strong. Overall, municipal returns were driven primarily by duration and yield curve positioning, with the long end of the yield curve continuing to underperform.

The dislocation in taxable municipal valuations can be seen more clearly by viewing bonds rated AA, which ended the quarter at an average credit spread of +103bps, while AA corporate bonds ended the quarter at an average credit spread of +87bps. When considering the strong fundamental backdrop for municipal credit, the current level of AA taxable municipals relative to AA corporate bonds points to an attractive buying opportunity, especially for an asset class that has proven resiliency during economic downturns.

Although rate volatility is inevitable, we anticipate an improvement going forward, which could be a catalyst for spreads to tighten back to their fundamentally justified levels. While inflation has yet to break out definitively to the downside, expectations declined during the second quarter’s last few weeks. Sentiment shifts for fixed income will likely occur as investors should continue switch between concerns over inflation versus recession. These environments typically produce favorable conditions for putting cash to work.

Supply

Overall municipal supply of both taxable and tax exempt bonds declined by 11.7% from the same period last year to $208.2 billion, primarily because refundings dropped 47%. The market selloff appears to have stalled the ability of many issuers to refund existing issues, at least temporarily.

Taxable municipal supply declined by 44% for the quarter compared with the second quarter of 2021. Taxable supply increased dramatically after the Tax Cuts and Jobs Act of 2017, and now regularly makes up approximately 20% of the new issue market under normal circumstances. If interest rates stabilize, we may see a catchup period of taxable new issuance after a sluggish first half of the year.

Demand

Despite being difficult to track, there is evidence of building demand in the taxable municipals market, especially from liability-driven investors. In June, the market experienced positive performance in the longest duration areas of the Bloomberg Taxable Municipal Index, where bonds longer than 15 years of duration returned +0.37%.

The increased yield and credit spread levels for the asset class should continue to attract demand from liability-driven investors. However a more stable rate environment should also bring total return investors into the market as well, as municipal credit should continue to remain stable amid economic uncertainty.

Defaults

Year to date through June 2022, first-time municipal bond defaults totaled just $672 million, a minute percentage of the overall $4 trillion market, and were predominantly tax-exempt. Defaults are mainly concentrated in nursing homes and industrial development revenue bonds, categories which include arguably the most idiosyncratic risks. Overall, we do not anticipate municipal payment defaults becoming widespread and do not see defaults occurring in any meaningful way within the high quality taxable municipal market.

Credit spreads

Credit spreads for the Bloomberg Taxable Municipal Index widened during the quarter by +16 bps, with all the momentum occurring during April and May. However, once the interest rate environment showed signs of becoming more range bound in late May, credit spreads began to tighten. After peaking at +123 bps in late May, the index’s credit spreads tightened to end the quarter at +111 bps.

This movement in spreads displays how technical factors within the taxable municipal market on a year-to-date basis have been closely related to volatility in U.S. Treasury rates.

With relative valuations being so attractive, demand should rapidly improve in a more range-bound interest rate environment. In such a scenario, credit spreads could narrow and performance could improve materially.

Ample reserves cushion government budgets

State and local governments have ample tools to weather an economic downturn. Their coffers are flush with cash, boosted by strong revenue collections. Reserve levels and revenue collections are at the highest levels in at least 40 years, and federal funds are easing the pressure on expenditures.

Total reserves are anticipated to be $262 billion in 2022, a significant 25% of expenditures. State rainy day funds reached a record collective high at $132 billion in 2022, or 13% of expenditures.

State and local tax revenue collections increased 22% in 2021 compared to 2020 and sit 20% above 2019 pre-pandemic levels. States reporting thus far show a 66% revenue growth from the previous quarter, and up 21.3% from 1Q 2021.

At the same time, overall budgets increased by only 7%. Initial stimulus funds helped ease pandemic related expenses, and funds from the American Rescue Plan Act (ARPA) and the Bipartisan Infrastructure Law (BIL) will help keep expenses at bay. ARPA funding must be used by 2024, and BIL funding for infrastructure projects will begin in 2022. Pension investment returns were so strong in 2021 that actuarially determined payments in fiscal 2023 will be lower. State pension funds are expected to be more than 80% funded for the first time since 2009.

Moody’s issued 89 upgrades and 25 downgrades in the first quarter of 2022. This compares with 817 upgrades and just 307 downgrades in 2021, and 296 upgrades and 209 downgrades in 2020. Given the strong revenue environment and record reserves, we believe municipal credit is well prepared for a recession in the event the Fed were to over-tighten.

Municipalities are in a historically strong position

California budget prepares for the next recession

On 30 Jun 2022, Governor Newsom signed the $308 billion FY22-23 California State Budget. The General Fund budget alone totals $234.4 billion, 3.5% lower than the revised 2021-22 budget, but 3% higher than the May Revision. The budget reflects a $49.2 billion discretionary surplus, with 93% of that expected to be spent on onetime projects. The budget projects California and the nation’s economy will continue to expand, but at a slower pace than originally proposed in January 2022.

A $17 billion inflation relief package includes a minimum wage increase, a one-year suspension of the diesel sales tax, assistance for rental housing and utility bills, subsidized childcare and small business assistance. The relief program’s centerpiece is a return of tax proceeds ranging from $200 up to $1,050 based on income level and size of household. It also allocates additional funds to help address the statewide drought, improve energy systems reliability over the next five years and provide incentives for climate-positive projects.

The budget continues to help California prepare for the next economic recession by depositing funds into reserves and reducing retirement liabilities, as well as prepaying state debts. The budget provides for $37.2 billion in total budgetary reserves, including $23.3 billion in the rainy day fund, $9.5 billion in the Public School System Stabilization Account, $900 million in the safety net reserve and $3.5 billion in the traditional General Fund reserve.

The Rainy Day Fund is now at its constitutional maximum (10% of General Fund revenues) meaning any excess revenues that would have been deposited into the Rainy Day Fund must be spent on infrastructure. Another $8 billion of supplemental deposits into the Rainy Day Fund and the safety net reserve are forecasted over the next few years.

The budget also includes a plan to prepay callable general obligation (GO) bonds over a multiyear period and to finance projects with cash rather than borrowing to further build budget resiliency. Supplemental payments of $3.4 billion toward the state’s pension liabilities – above and beyond what is actuarially required – are included in the 2022- 23 budget, and another $7.5 billion of supplemental payments are projected over the next three years.

Illinois’ rating receives upgrades

Illinois’ strong revenue growth and improved fiscal management have boosted the state’s credit quality and helped net several rating upgrades. Fiscal year (FY) 2021 revenues far exceeded initial projections, coming in nearly 20% over the prior year. The unanticipated tax revenue, combined with the influx of federal stimulus dollars, precluded the need for expenditure cuts or tax increases.

Illinois’ recently adopted FY23 budget is a stark departure from recent years. Revenue assumptions are considered conservative, with net general fund revenues essentially flat year-over-year. The $46.5 billion General Fund budget fully funds operations, including education funding increases, a tax relief package and a projected $770 million surplus to be applied to several new policy priorities. The state plans to contribute $1 billion to a new budget stabilization fund using surplus revenues from FY22 and FY23. This will be the first time Illinois has made a deposit into a reserve fund in 18 years.

An additional $500 million will go to a pension stabilization fund, representing a payment above the statutory pension requirement. The state estimates the contribution will result in $1.8 billion in long-term savings. Recent surpluses have enabled Illinois to eliminate the historic bill backlog and fully repay funds borrowed from the federal government and inter-fund borrowing.

Rating agencies were quick to take note and recent upgrades reflect the steady improvement of the state’s financial situation over the last two years. Following an upgrade in 2021, Moody’s upgraded the state again in April 2022, raising the rating to Baa1/Stable. Fitch upgraded the state by two notches in May 2022 to BBB+. An S&P upgrade to BBB+ followed.

Illinois remains the lowest-rated state. Given the state’s broad taxing authority and large economy, a rating in the BBB category is still well below where a state should be. Above-average fixed costs, debt and comparatively weaker financial position are likely to keep the rating lower than peer state’s despite above-average income levels and other credit strengths. The state’s pension and debt service costs amount to about 30% of total revenues, which is substantially higher than the state median of 10%. This severely constrains budgetary flexibility and makes the state more vulnerable in future economic downturns because it is less able to provide aid to local governments in need.

Toll roads and airports bounce back

The toll road sector was among the quickest to recover from the pandemic, with traffic levels rebounding faster than anticipated once governmental lockdowns and restrictions were eased. According to Federal Reserve Economic Data, vehicle miles traveled (VMT) in America during April 2020 declined 39% versus the prior year and reached its lowest level reported since 1994. As economic activity steadily improved over the ensuing 12 months, VMT during April 2021 had already rebounded to 95% of April 2019 activity.

Many experts had predicted that 2022 traffic levels nationwide would finally reach pre-pandemic levels, but VMT as of April 2022 was still running approximately 4% below April 2019 results. We attribute this recent flatlining of traffic to rising gasoline prices during the first half of 2022 and greater than anticipated remote work activity 2+ years into the pandemic. Nonetheless, we continue to view the toll-road sector as a resilient asset class with a strong track record of surviving downturns.

The airport sector took somewhat longer to see passenger traffic recover, due to the ongoing restrictions and a lingering fear of public transportation. However, it is now experiencing a strong recovery, and most airports are observing passenger traffic at or near pre-pandemic levels. Domestic leisure travel is now exceeding pre-COVID levels at many airports, while international and business travel have been slower to recover. TSA daily checkpoint travel data (the daily throughput at all TSA checkpoints) during June 2022 was approximately 90% of the June 2019 average.

Prior to the recovery in air travel, and corresponding revenues for airports, the sector benefited from solid pre-pandemic liquidity that was further bolstered by three rounds of financial support from the federal government.

For the balance of 2022 and 2023, we expect air traffic volumes will continue to recover as business travel and international travel continue to catch up to the already strong leisure segment.