- In 2Q 2022, interest rates rose, yields moved sharply higher, and investors sold municipal bonds to make tax payments, spurring outflows that challenged municipal bond market liquidity. As a result, credit spreads are now wider and municipals are cheaper relative to other fixed income alternatives.
- Municipal bond fundamentals, however, are solid: Spread widening has created opportunities to invest in research-recommended credit and build a better yield cushion. Although we believe that municipal credit will continue to benefit over the next 12–18 months from previous government support, we remain vigilant for any signs that an economic slowdown will put pressure on revenues.
- We expect continued volatility in the market as the Federal Reserve (Fed) raises interest rates and pares its balance sheet. This policy shift has created an opportunity for clients that have been underweight fixed income because of the low rate environment to take advantage of attractive municipal valuations.
- Clients may want to closely evaluate their liquidity needs and consider bond strategies that have less than one year’s duration because the opportunity cost of overestimating or underestimating cash needs has increased. Additionally, clients may want to consider rebuilding their core portfolios given the substantial increase in yields and attractive relative value of municipal bonds.
Rediversifying portfolios as interest rates rise
The past few years have been challenging for fixed income investors as steadily declining interest rates and strong corporate fundamentals have tilted asset allocation toward risk assets—and away from traditional fixed income. This year, ongoing supply chain disruptions, tight labor markets and commodity shortages sparked by Russia’s invasion of Ukraine have raised inflationary pressures. The Fed, recognizing the need to respond more aggressively, made an abrupt, hawkish pivot this spring, and interest rates spiked.
In this issue, Margaret Byrne, Senior Fixed Income Specialist, discusses opportunities in the market and portfolio positioning with Richard Taormina, Portfolio Manager and Head of Tax Aware Strategies.
MARGARET BYRNE: Early this year, the market was positioned for an eventual and moderate Fed tightening cycle. Instead, as it became evident that inflation was going to be stickier than predicted, the market went on the defensive. And then war broke out.
RICHARD TAORMINA: The Fed came into the year still signaling that inflation would be transitory and carefully monitoring whether the economy could stand on its own—and whether the COVID-19 pandemic was finally over. That approach changed in January, when the Fed made an abrupt pivot and signaled its willingness to take more aggressive action. Interest rates moved sharply higher.
As rates rose—and we approached the April tax season—municipal bond mutual fund outflows began. As you recall, in 2021 we saw record inflows into these mutual funds: Investors were anticipating an increase in tax rates that never materialized and targeting the higher embedded yield available in mutual funds. The introduction of sharply higher interest rates in early 2022, however, spooked investors and those fund flows reversed. That shift set off a chain reaction: Continued outflows made it difficult to position municipal bond inventory, so liquidity began to evaporate, as it did across many other fixed income sectors. On top of that, tax time typically puts pressure on the muni market as clients sell bonds to pay taxes, so munis became cheap.
MB: Are munis finally at attractive levels vs. Treasuries and corporates?
RT: Previously, ratios were at levels that made it mathematically uneconomical to own municipals; this year’s dramatic repricing, however, has brought munis back to levels that make them very attractive to investors in the highest tax brackets, as well as corporations and insurance companies. To put this in perspective: In December 2021, an individual buying Treasuries instead of munis would have been better off by 16 basis points (bps) on a five- year maturity; AAA munis are now outyielding Treasuries by 80bps on a five-year maturity and by 120bps on a 10-year maturity after tax (Exhibit 1). Even corporations, which pay a 21% tax rate, can pick up 23bps of after-tax yield on five-year bonds and 64bps on 10-year bonds by buying munis instead of Treasuries. The pickup is even more dramatic on AA-rated munis, which have widened this year vs. AAAs.
The bond market’s dramatic repricing in early 2022 has made municipal bonds attractive once again to individual and institutional investors
Exhibit 1: AAA municipal bond yield pickup vs. Treasuries (after tax)
MB: Municipal credit has benefited substantially from a strong U.S. economy and significant fiscal stimulus. Municipal pension funding levels are up and reserves are near record levels, a testament to ample resources and strong management. But challenges arising from the Fed’s recent actions—as well as the crisis in Europe—can potentially put pressure on the U.S. economy and municipal operations if costs rise and labor shortages appear. How vulnerable are municipalities to these changing market conditions?
RT: Municipalities have continued to manage their budgets conservatively and responsibly. Municipal managers have learned a lot since the global financial crisis (GFC) of 2008–09, when they received significantly less support from the federal government. In the aftermath of that crisis, they were forced to chip away at their structural deficits by aggressively refunding debt as interest rates declined; they did not significantly increase leverage. In fact, the muni bond market has barely grown in 10 years—a notable feat when compared to the increases in debt issuance by the U.S. government and corporations.
Municipalities have also been conservatively managing expenses since the GFC. In doing so, they were able to enter the COVID-19 crisis in much better shape. Still, when COVID hit, they aggressively revised down revenue estimates and used reserves, interfund borrowing, spending cuts and furloughs to balance budgets. Importantly, they received an unprecedented amount of direct and indirect support from the federal government. Revenues rebounded quickly after a short disruption and federal fiscal support further bolstered balance sheets. That support is part of the reason we believe strong muni fundamentals will remain intact. Municipalities have still not spent a significant amount of federal aid, which should help dampen any unforeseen impacts as policymakers at the Fed try to lower inflation and navigate a soft landing.
MB: How resilient are municipalities likely to be in the event of another major economic slowdown?
RT: We think municipalities will continue to benefit from strong personal income and property tax receipts. If the economy slows, we will likely see sales taxes soften, and that’s where the reserve fund cushion may come in handy. We continue to monitor revenue trends for any signs of weakening across all muni sectors on a monthly and quarterly basis, and will be diligently monitoring credits held across the entire municipal platform. For now, we are still constructive on municipal credit and will continue to take advantage of the current market dislocation to add yield on a risk-adjusted basis.
MB: Given this backdrop, what should investors consider?
RT: With cash finally yielding more than 0%—and ultra-short strategies picking up a significant amount of yield— clients should carefully consider their liquidity needs. The opportunity cost of overestimating or underestimating those needs has increased, and markets are volatile, which could hurt investors when they require liquidity. Conversely, clients with a longer cash spending runway may pick up excess yield by stepping out to bond strategies with less than one year’s duration, because the market has already priced in most of the rate hikes we expect this year.
Clients may also want to consider rebuilding their core portfolios. Absolute yield levels are back to figures not seen for some time, and the Fed will do whatever it takes to bring inflation down, which means slowing the economy. This imperative should keep interest rates from moving up substantially. Core portfolios that offer attractive yields may provide ballast to clients’ overall portfolio allocations.
For clients slowly moving out the curve, implementing a combination of ultra-short duration and core bond strategies may help manage duration risk while taking advantage of the steepening yield curve and rising rates. Finally, for the first time in years, clients can tap into a store of value, and they may want to consider tax loss harvesting1 to offset current or future gains in other parts of their portfolios.
1 Tax loss harvesting involves selling a bond at a loss and reinvesting the proceeds in a similar but not identical security. The strategy permits the investor to generate a tax loss that can be used to offset gains, thereby minimizing capital gains taxes.