Can a Technical Headwind Turn Into a Tailwind? We Think So.

Posted by Lawrence Gillum, CFA, Fixed Income Strategist

Wednesday, January 25, 2023

To say that last year was a bad year for fixed income investors would be a huge understatement. With the Federal Reserve (Fed) embarking on the most aggressive rate hiking campaign since the 1980s, most fixed-rate coupon bond markets delivered the worst returns many investors had seen in decades. And while the national municipal market was the “best” performing major fixed income market in the U.S. last year, the normally staid market was still down -8.52% in 2022.

The pressures from the Fed raising rates at a historic clip was a primary driver of the negative returns, though, the technical pressures also negatively contributed to the decline. Fixed income technicals, which are different from looking at price patterns, refer to the changing supply and demand dynamics within a market. When demand outpaces supply, that tends to be a technical tailwind and vice versa. Within the muni market, supply of new bonds was down last year, which should have helped, but demand fell off a cliff.

Muni investors pulled over $151 billion out of open-end mutual funds last year (according to ICI), which represented 11% of starting assets under management (AUM). In other words, the muni market shrank by 11% last year due to investor redemptions. The municipal market is a relatively illiquid market so the magnitude of redemptions helped push muni prices down lower than their strong fundamentals and attractive valuations warranted, in our view.

View enlarged chart

But that was last year—what could the technical picture look like in 2023? Historically, positive demand and strong performance tend to follow an outflow cycle. According to analysis by Western Asset Management, there have been seven previous outflow cycles (since 2008) that averaged over $30 billion in investor withdrawals. The subsequent inflow cycle saw investors, on average, add back over $97 billion to muni funds. Interestingly, during those outflow cycles, the muni market was down around 2% but after the inflow cycle, the index was up, on average, 13%. Certainly, there are no guarantees the past will repeat itself, but we do think the technical headwind is largely behind us. And with the Fed likely slowing the pace of rate hikes in the coming months, still attractive valuations, strong fundamentals, and perhaps a pick-up in investor demand could mean better days are ahead for muni investors.


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