Posted by Lawrence Gillum, CFA, Chief Fixed Income Strategist
Tuesday, September 12, 2023
It’s been another volatile calendar year for municipal (muni) investors. While generally outperforming taxable core bonds so far this year (as proxied by the Bloomberg Aggregate Bond Index), the Bloomberg Muni Index has underperformed what could be expected from coupon payments alone. So with the last few months of 2023 upon us, the following are five things muni investors should be aware of as these last few months of 2023 come into view.
- The muni curve is almost always steeper than the Treasury curve due to uncertainty about future tax rates, as well as strong demand from individuals for bonds maturing within 10 years, and because longer-dated issuance is normally tied to the expected life of an individual project. While this remains the case, for the first time in decades the municipal bond yield curve is inverted, which provides some interesting opportunities. Core fixed income portfolios could use a barbell strategy to capture the cheapest parts of the curve—the very front end and between 10 and 20 years
- Many fixed income investors experienced the worst year on record in 2022. And while 2022 wasn’t exactly the worst year ever for muni investors, it was close. So, understandably, last year was the worst outflow cycle for munis in recent memory. And while better than last year, outflows from mutual funds have persisted with over $8 billion withdrawn this year, despite the attraction of higher starting yields. While valuations and fundamentals remain attractive, until outflows slow, returns could be volatile.
- That said, new issuance trends remain below averages. With interest rates elevated and many municipalities in good financial health, the need to access the capital market has been muted. Last year was a relatively light year for new supply but because of the record amount of outflows, the positive supply/demand technical didn’t really help investors. This year, while outflows continue (see above), the very light supply has helped (marginally) keep prices well bid and could further support prices once investors re-enter the market.
- While many equity investors are familiar with seasonality trends, fixed income investors may not be as versed. Generally, after the summer doldrums, new issuance tends to pick up, which puts downward pressure on prices (upward pressure on yields). However, as mentioned above, new issuance remains muted. And like the other months this year, which 2023 has so far bucked the trend, the typical seasonal patterns may not hold throughout the rest of the year. But if they do hold, muni investors could end the year with a positive tailwind to returns.
- Last month, Moody’s, a rating agency, updated its historical default rate analysis between munis and corporates and the story didn’t change. Munis have, by far, better default characteristics. So, while Investment grade munis have underperformed highly rated U.S. corporates so far this year (not tax-adjusted), munis tend to outperform corporate debt during economic slowdowns. Moreover, the default rate for munis is significantly better than corporate borrowers. The cumulative muni default rate for investment grade issuers (between 2013 and 2022) was just above 0 versus 1.9 for taxable corporate bonds. Additionally, the high yield muni credit default rate was around 4.0%, cumulative, versus 32.5% for high yield corporates. With valuations improved relative to corporate bonds, we could see crossover interest return for munis, which could help offset some retail outflows.
Bottom Line: While munis have outperformed a number of taxable fixed income markets this year, after the historically bad year last year, it probably hasn’t been the year (so far) that many muni investors had hoped for. But, with the Federal Reserve close to the end of its rate hiking campaign, we could see a smoother path for munis over the last few months of the year. Despite a slowing economy, fundamentals are still strong compared to history. And while tax revenues may have peaked, high cash balances and reserves should allow most issuers to adapt to an economic slowdown. Total yields remain above longer-term averages and since starting yields are the best predictor of future returns (over longer horizons), we think high quality munis remain attractive.
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