Weekly Investment Commentary: Municipal bonds: Time to test the waters again
Bottom line up top
- Municipal markets appear to be turning a corner. May marked the first positive monthly return (+1.1%) for the Bloomberg Municipal Bond Index since November 2021, and only the third over the past year. Of course, one month of performance doesn’t make a trend, and munis are still down sharply (-9.0%) year to date. But we think the worst of the damage wrought by soaring yields and Fed policy uncertainty may be behind us.
- The fundamental things apply. The 2022 selloff has been driven by technical and macro factors, not asset-class specifics. Muni credit fundamentals have remained quite healthy even as valuations have fallen. Consider:
- State and local tax revenues collections increased 15% in 2021 — the highest in 30 years — and collections in 2022 are on track to be even stronger.
- State reserves/fund balances are currently at 23% of expenditures, on average, the best since 1979.
- State pension funded ratios are topping 80% for the first time since 2008.
- Most muni sectors have a stable or positive ratings outlook. Last year, Moody’s issued 817 upgrades and only 307 downgrades.
- When will investors return? Despite sound fundamentals and improved performance, investors have been pulling money out of muni funds in historically large amounts — roughly $63 billion year to date through May. This reflexive response is in keeping with a familiar pattern that almost seems like muscle memory: heavy muni fund outflows whenever yields start to rise (Figure 1). Negative flows have been the primary driver of today’s cheaper municipal bond valuations, which could represent an attractive entry point for those willing to dip their toe back into the muni waters. In the discussion that follows, we take a closer look at these opportunities and where they may fit in diversified portfolios.
“While municipal bond prices and valuations have fallen, fundamentals still look sound. That’s a positive signal.”
Portfolio considerations
In an uncertain macroeconomic environment, diversification and thoughtful risk allocation take on heightened importance. In addition to our bias toward higher quality (including higher-quality high yield), municipal bonds can be a very useful tool within fixed income allocations.
Adjusted for taxes, AAA munis currently offer greater income than Treasuries and are competitive with investment grade corporates (Figure 2). Given that corporates are much lower quality (A/BBB), we believe municipal bonds offer more efficient yield per unit of credit risk.
“Comparisons to Treasury and corporate yields suggest we could be seeing an attractive entry point for municipal bonds.”
Additionally, current yields indicate a favorable entry point for munis on the front end of the yield curve. This provides a potential yield advantage without the need to increase interest rate sensitivity. The ratio of the same muni and corporate yields from Figure 2 is 1.2 standard deviations in favor of municipals at one year of maturity. At three years, the ratio is 0.8 standard deviations favorable. Importantly, we compare municipals with corporate bonds rather than Treasuries since munis and corporates are the two most salient options for the purposes of stepping out of cash and generating incremental income.
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Endnotes
Sources
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