In 2023, Munis and Treasuries moved in lockstep, and flow dynamics roiled the market. Investors need to be mindful of technical factors amid bountiful yields.
Higher for Longer: Another Tough Year for Bonds
After a challenging 2022, the municipal bond market showed relative stability in the first half of 2023, with outflows slowing down considerably and liquidity recovering to healthier levels. But Muni market sentiment turned volatile in the latter half of the year, triggered by the U.S. Federal Reserve’s decision to hike the Fed Funds rate by 25 basis points in July and maintain a steady policy in September.
Municipal Bond Monthly Performance Was Negative until November, Like 2022
Source: Bloomberg, ICE BoA
There were signs that the U.S. Federal Reserve might be approaching the end of its rate hike cycle in September while indicating its commitment to keep rates higher for longer to continue combating inflation. In response, the market sent Treasury yields surging, and bond prices fell across the board in September, as seen above. Muni bonds joined the rout, with yields soaring on top-rated Muni credits and bond prices diving. But Muni bond performance took off in November as tax-loss selling abated and investors sought to lock in higher yields should Fed policy remain steady or even ease in reaction to a widely anticipated, if much delayed, recession. As a result, 2023 is looking to wrap up as a flat to strong year for Munis, bucking the trend in broader fixed income markets.
Munis Performance Remains Vulnerable to Technical Drivers
Historically, households (i.e., individual investors) owned nearly half of the outstanding debt, and these investors would hold bonds until maturity while consistently reinvesting the coupon and principal amounts. This investor behavior coupled with bond issuers making coupon payments in January and July created seasonal demand for bonds. However, household ownership has declined, as seen below, while managed funds, including Exchange Traded Funds (ETFs), now absorb a larger share of outstanding Munis. ETF assets have tripled since 2019.
Household Ownership of Muni Bonds Is in Decline, Leading To Volatility
Source: Federal Reserve Chart of Accounts
While investors have appreciated the daily trading frequency of mutual funds and ETFs’ intraday action, ETFs can amplify market movements given their enhanced liquidity features and ability to trade at a significant discount or premium to their underlying assets. The latter is especially true during times of stress, as was seen during the September panics of 2022 and 2023 when retail investors ramped up selling pressure or redemptions. That, in turn, forced mutual funds and ETFs to sell, exacerbating an already volatile situation and triggering steep declines in bond prices.
Heading into 2024, we believe fund flow dynamics of mutual funds and ETFs will remain among the key drivers of short-term Muni market volatility and performance. On the bright side, the heightened volatility presents unique opportunities for active managers to recognize market overreactions and capitalize on market selloffs. When bond prices fall indiscriminately across the board due to technical, momentum-driven factors, this creates the perfect opportunity for active managers to secure fundamentally sound municipal credits at discounted prices and bountiful yields.
Looking Forward to 2024
We believe current market sentiment is too dependent on the latest economic indicators as investors attempt to predict the Fed’s next move. For instance, the recent drop in inflation figures led many to believe the central bank would pause rate hikes, with some even discussing a potential Fed pivot to rate cuts — and that sentiment pushed yields lower. We think these sorts of short-term repricings have not only been historically misguided, leading to being inaccurate, but can also be distracting and counterproductive to providing long-term value for bond investors.
Moreover, bond and equity investors are becoming hypersensitive to daily economic headline news in the current environment, and collective efforts to “read the tea leaves” have adversely impacted the relationship between U.S. Treasuries and Munis. In the past, municipal price movements tended to follow similar patterns to those of Treasuries, with Munis generally lagging Treasuries by a few weeks. But Munis have become so tightly tethered to what is happening in Treasuries that these asset classes now move in lockstep, nearly daily, with minimal differentiation between stronger and weaker credits.
Bountiful Yields in High-Quality Credits
Bond yields have risen to levels not seen in decades, and investors shouldn’t miss the opportunity to lock in here and take advantage of the heightened levels of income. Opportunities in Munis are even more compelling when investors consider the tax-exempt benefit, especially in high-tax states.
As seen below, AAA-A rated municipal credits offer much higher yields than similar-quality corporate bonds and government-backed Treasuries across five-, 10- and 30-year periods. It is also worth noting that, over a decade, the tax-adjusted returns of A-rated municipal bonds currently rival those of equities. Essentially, Munis could potentially provide equity-like returns with lower risk than stocks.
Getting Paid Well to Own High-Quality Muni Credits
Source: Bloomberg BVAL Yield Curves
Stability and Protection in Municipal Bonds
Municipal bonds are often considered a relatively stable and protective asset class because they tend to be less susceptible to economic headwinds, as most of them are backed by the financial strength of the state or local taxing authorities or specific income streams from various projects. That makes it critical to comprehensively understand the fiscal health and debt profiles of the local government entities issuing Munis.
Contrary to popular belief and unlike the federal deficit challenges, municipalities exhibit remarkably low levels of debt in comparison with other sectors of the economy, underscoring the strength of this sector’s financial health. We think Munis are uniquely positioned to be a cornerstone of investors’ portfolios due to their strong sector fundamentals, resilience, and long-term stability.
State and Local Governments Carry Less Debt
Source: Federal Reserve Chart of Accounts
Outlook and Positioning
The recent resilience of the U.S. economy surprised many investors who came into 2023 expecting a recession. That strength has led many to reassess and price out near-term recession risks. While there is ample debate about the possibility of a soft landing or whether the current environment is the calm before the storm, we remain attuned to the ever-evolving macro environment while maintaining an unwavering focus on bottom-up credit fundamentals to drive portfolio outcomes.
Turning to 2024, Munis are an enticing investment option given this asset class’s attractive tax-equivalent yields and protection. In particular, we believe specific municipal sectors are positioned to perform better than others based on our outlook for each, as summarized below.
Outlook
Yields
The post-Global Financial Crisis high in Municipal yields reached at the end of October may prove to be a cycle high. The Federal Reserve’s shift away from a hiking regime seems likely, however, we do not believe that will usher in an immediate easing cycle. It has paid to take the Fed at its word for the last several years and we see no reason that will change in 2024.
Credit/Sector
The credit quality of municipal borrowers has been very strong over the last several years but is likely to decline even without a recession. Data points suggest the economy is slowing and will lead to lower tax revenue collections, put pressure on budgets, and lead municipalities to draw down the reserve funds built over the last decade.
Defaults
Municipal defaults have remained low in historical context but there has been a rise from year-to-year. The increase has been focused in areas that were challenged prior to the pandemic but whose problems were exacerbated by it. We expect this trend to continue where economically sensitive areas of the market will face challenges. That’s not to say we are ringing the alarm. We do not expect a rash of defaults, but credit research is paramount going forward.
Positioning
Yields
The higher absolute level in yields created, combined with a slowing in Fed rate hikes created an environment where extending duration is additive to portfolios. The benefit is two-fold: the immediate increase in income generation for portfolios and the potential upside in bond prices should rate cuts occur in the first half of 2024.
Credit/Sector
Credit spreads widened in conjunction with yields moving higher in 2023. This created the opportunity to be compensated for taking risk, but investments were made judiciously. We favored the lower-end of the investment-grade space while avoiding the Pavlovian response of buying high yield municipal bonds after a sell-off because of where we are in the credit cycle.
Defaults
Our natural predilection is to a high-quality bias in our strategies because we believe the historic low default rates in the investment-grade space aligns with the goals of municipal investors. We have ramped up on our credit surveillance efforts to mitigate defaults and jettisoned credits that may face undue challenges in the future. We have also avoided project finance deals funded with the rosiest of projections during the economic expansion that are struggling to meet construction or revenue goals.
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