Of all the twists and turns taken by equity and bond markets this year, one of the most dramatic has been occurring in the municipal bond market. While muni bond/U.S. Treasury ratios have historically hovered around 75% to 85%, they shot above 100% in May. For a brief period, an investor could source tax-free income through high-quality municipal credits where prevailing yields outpaced the taxable yields available on government-backed debt.
Not everyone was nimble enough to take advantage of this opportunity while it lasted. Muni bonds rallied in late May and muni/Treasury ratios came in substantially. While this may or may not be the end of the peak opportunity for munis in today’s environment, we think it’s instructive to review how the dislocation came about in the first place, the types of opportunities it revealed, and where markets may be headed next.
Factors that led to the recent opportunity in munis
Interest rates have risen quite sharply for much of the year to date, with inflation—rather than any sort of credit market disruption—as the primary culprit. Inflation has been running hot since the beginning of the year, coming in at around 6% to 7% year over year, well above the U.S. Federal Reserve’s (Fed’s) preferred 2% inflation goal. This led the Fed to make an abrupt shift higher in its outlook for raising rates during the course of the year. As a result, 10-year U.S. Treasury yields rose rapidly toward the 3.25% area, only to be quickly repriced back into the 2.75% to 3.00% range, although the prospect of continued elevated rates remains.
The rapid shift higher in interest-rate expectations led to forced selling in municipal bonds, with mutual fund outflows gathering momentum from tax-loss harvesting and general risk aversion. The moves have been volatile and disorderly, but they’ve also created opportunities for those investors—like us—who had the wherewithal to be a liquidity provider to the market when indiscriminate selling took hold.
Preferred muni sectors
Our active approach to muni investing prioritizes intense bottom-up fundamental credit analysis, which we believe is the most effective way to identify opportunities in the muni market. Among the two main classes of muni bonds—general obligation (GO) and revenue bonds—we’re more favorably inclined toward revenue bonds, which are backed by dedicated revenue streams as opposed to the unsecured/good faith provisions of GO bonds. Within revenue bonds, we favor the healthcare sector (hospitals and senior living), which continues to strengthen through a multi-year trend of merger activity.
Additionally, certain industries that were deeply affected by the COVID-19 pandemic, including transportation (toll roads and bridges) and education, continue to appear attractive. We also believe that high-quality, highly liquid GO exposure, if acquired at attractive valuations, can help position muni bond investors to benefit from the gradual recovery of the market from the spring's interest-rate/technical-driven sell-off.
Munis have a solid tailwind
Historically, munis have demonstrated solid performance following periods of stress. While not immune to drawdowns, on average, munis returned 12.15% in the 12 months following a drawdown compared with an average return of –7.6% during the drawdown.
The nature of the most recent sell-off gives us confidence that munis may continue the recovery trend in today’s environment. Regardless of the pricing dislocation, credit fundamentals remain historically strong in our view, and like prior drawdown periods, we expect that munis will continue to experience a recovery as technical crosswinds stabilize.
Where do we go from here?
In the current environment, we expect state and local municipalities’ balance sheets to exhibit continued strength as they receive a double boost from record federal fiscal stimulus and an improving tax base. In fact, monthly tax collections for the 41 states that report collection data have shown an average increase of 28% over budget for the 2022 fiscal year.1 With the positive fundamental backdrop, we see current valuation levels for municipal bonds relative to U.S. Treasuries as a unique buying opportunity that could allow investors to capture attractive tax-exempt yields without adding significant potential credit risk.
1 Bloomberg, June 2022.
Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Municipal bond prices can decline due to fiscal mismanagement or tax shortfalls, or if related projects become unprofitable. Investments in higher-yielding, lower-rated securities include a higher risk of default.