In Brief

• Municipal bonds may provide strong diversifying benefits vs. risk assets. After a difficult 2022, yields now offer value, particularly bonds of 10 years and longer.
• The return of coupon cushion should offset some of the rate volatility we expect lies ahead as the central bank navigates economic and geopolitical uncertainties.
• Municipal issuers are generally well positioned to face macroeconomic headwinds from higher costs, a tight labor market and, potentially, a recession, shored up by strong reserves, pandemic aid and conservative budgeting practices.
• Security selection and strong oversight become even more important during periods of economic weakness.  

After a year of significant repricing, higher yields are back

What a difference a year makes.

The significant and broad-based repricing of municipal bonds that occurred in 2022 after years of super low rates may mean the market once again can offer investors strong diversification vs. risk assets (Exhibit 1). Higher yields are back—a source of return that should cushion some of the rate volatility we expect lies ahead as the Federal Reserve (Fed) navigates economic and geopolitical uncertainties.

Significant, broad-based repricing occurred last year across the municipal bond market as inflation drove sharp Fed rate hikes

Exhibit 1: Change in yield (%), 2-, 5-, 10- and 30-year AAA general obligation (GO) public improvement bonds 12/31/2021 to 1/13/2023

Source: Refinitiv TM3; data as of January 13, 2023.

The Fed moved aggressively in 2022, taking the fed funds rate sharply higher, from 0% to 4.25% as of December, as inflation rose to levels not seen since the early 1980s. The Fed’s actions helped slow the rate of price increases. However, the labor market is still strong, suggesting that wage pressures could keep overall inflation some distance from the Fed’s target, at least for a while.

In 2023, as the Fed moves closer to the end of the hiking cycle, higher yields and rate stability should support flows into fixed income generally, including the municipal bond market.

We expect supply will drive valuations

In 2022, supply was down, especially later in the year. Higher interest rates took their toll on the issuance of taxable refunding bonds. We anticipate that issuance will remain flat again this year, with seasonal drivers likely creating volatility in valuations (Exhibit 2).

We expect issuance to remain light again this year

Exhibit 2: Municipal bond issuance 2019–23 (forecast), $ billions

Source: J.P. Morgan Asset Management; data as of December 31, 2022. AMT: includes bonds subject to the alternative minimum tax.

We expect strong technicals early in the year will put downward pressure on the ratio of municipal yields to Treasury yields until issuance picks up in February. Municipalities may tap the market to fund some pay-as-you-go projects to help smooth out revenue shortfalls. 

Flows that drove the yield curve in 2022 should create value in 2023

Fund flows into the market drove the yield curve last year, flattening the parts of the curve where flows from separately managed accounts and ETFs were solid. Meanwhile, record mutual fund outflows pressured the long end of the curve. Now we find yields attractive across most of the curve, and we see even more value in longer-dated bonds because of the shape of the curve (Exhibit 3).  

Muni taxable-equivalent yields are attractive across most of the curve

Exhibit 3: Treasury, AAA muni and AAA muni taxable-equivalent yield curves

Source: as of January 13, 2023.  TEY: Taxable equivalent yield is calculated using a tax rate (T) of 40.8% (AAA Muni / (1-T)). 

Municipal issuers’ credit fundamentals are solid

We acknowledge that municipal issuers are facing many macroeconomic headwinds, from higher costs, a tight labor market, lower revenues and, potentially, a looming recession. However, issuers are well positioned to weather the storm, shored up by strong reserves, pandemic aid and conservative budgeting practices that give many municipalities financial flexibility.   

Security selection and oversight become even more important during periods of economic weakness. Upgrades, which outpaced downgrades in 2022 by 2.5 to 1, will likely move closer to neutral. We expect no substantial worsening of the market’s low default rates. The average 5-year default rate since 2012 for munis has been 0.10%*—vastly lower than corporate bond defaults. 

Municipal issuance outstanding has been flat not only in the past five but also the past 10 years, reflecting the very conservative approach municipalities have taken to bonded debt (Exhibit 4).

Municipal issuers haven’t levered up

Exhibit 4: Debt and loans outstanding ($bn)

Source: SIFMA; data as of September 30, 2022.

Opportunity for higher yields

Clients may want to consider adding, or adding to, their core municipal strategies to take advantage of higher yields. Given the volatility in muni bond valuations vs. Treasuries, especially on the short end of the curve, we believe it makes sense to have the flexibility to buy Treasuries for those periods during the year, particularly January/February and July/August, when muni valuations become seasonally stretched.

*Source Moody’s as of 12/31/2021

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