Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Wednesday, June 1, 2022
The national municipal market has been under the same price pressures as the fixed coupon taxable markets this year as markets have aggressively repriced faster interest rate hikes from the Federal Reserve (Fed). Adding to these price pressures however has been the liquidation of nearly 5% of the muni market through investor redemption and fund outflows. Combined, national muni investors have experienced the worst start to the year in decades. But after the swift repricing that’s already taken place this year, munis are offering an attractive opportunity for taxable investors under most tax-adjusted scenarios.
“Of course, the path forward for Treasury yields and inflation is still uncertain,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “But the relative value proposition for munis has improved greatly this year. Coupled with much improved fundamentals, investors willing to handle elevated levels of price volatility could find today’s muni market levels an opportune time to invest.”
Over the past decade, the tax-exempt structure of the municipal market has provided around 50 basis points (0.50%) of incremental after-tax yield versus the respective Bloomberg corporate index. Now, as shown in the LPL Chart of the Day, the muni market is out-yielding (on a tax equivalent basis) the corporate market by nearly 100 basis points which is above the longer term average. And while the positive yield differential has retraced somewhat this month, we think the potential for further convergence to historical levels is possible, particularly over the summer months due to the positive summer seasonal found in the muni market.
So is the widening yield gap between munis and taxable corporates a market signaling the risk of muni downgrades/defaults has increased? We don’t think so. The fundamental picture for many state and local entities improved rather significantly during 2021. State and local operating budgets are in the best fiscal condition of our lifetimes, even better than the late 1990s, due to strong economic growth and the federal government’s financial support during COVID-19 shutdowns. Moreover, state and local governments are running their second consecutive year of surpluses for the first time since 1978. Additionally, as the economy recovers, state and local tax receipts should remain supportive of budgetary priorities
So what does that mean for muni investors? We think most of the rate move is behind us and we are seeing signs of outflows moderating, so we do expect muni performance to stabilize at current levels. Moreover, with recent stabilization in Treasury yields, it’s possible we’ll see additional institutional crossover buyers to take advantage of the excess yields in the muni market. And while interest rates could continue to go higher from current levels, the relative value proposition for munis has improved this year.
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