History suggests that 2023 could be a good year for the municipal bond market as yields and fundamentals should once again drive total return.
The streak of eight consecutive years of positive total returns for the broad municipal market came to an end in 2022 as the Bloomberg Municipal Bond Index posted its worst return in more than 30 years. The year was dominated by aggressive Fed tightening, persistently high inflation and growing concerns over a central bank induced recession, which led to a spike in yields and a decline in bond prices.
History Suggests that the Muni Bond Market Will Rebound in 2023Source: Bloomberg. Returns as of November 30, 2022.
Municipal yields finished higher across maturities while spreads widened across both credit quality, sectors, and states as investors became more discerning about the bonds owned heading into an economic slowdown. The spike in yields led short maturity bonds to outperform long maturity bonds while the widening of credit spreads led higher rated bonds to outperform lower quality bonds for the year.Source: Bloomberg. Returns as of November 30, 2022.
Yields Will Once Again Drive Total Return
Yields were up significantly in 2022 as the fixed income market focused nearly exclusively on inflation and the Fed’s late but aggressive reaction to swiftly rising price pressures. While negative price returns should be expected in periods of rising rates, the low starting point for yields exacerbated the negative performance for the year. Bonds purchased as recently as summer of 2021, when the broad market index was yielding less than 1%, lacked the income cushion that existed in prior periods of Fed rate hikes that helped offset the impact of price declines on total returns.
Investors who purchased bonds in 2019, 2020 and 2021 did so in a period of falling yields and rising prices which led to total returns driven by price returns, not income, which is uncharacteristic in the muni market. Over the last 30 years, 90% of the total return of the broad market index has been attributable to income and only 10% to price returns. The broad market index yielded over 3.5% in early December after briefly eclipsing 4% for the first time in a decade. Considering income is the only component of total return that is tax-exempt for municipal investors, it becomes even more attractive when adjusted for federal tax rates as seen in the chart below.
Municipal Bond Yields Surged in 2022, amid Aggressive Fed TighteningSource: Bloomberg
Regardless of which direction interest rates move in 2023, investors who may have extended the duration of their portfolio by purchasing longer maturity bonds or who reduced the credit quality of their portfolio by purchasing lower quality in reaction to the Fed’s Zero Interest Rate Policy (ZIRP) now have an opportunity to reduce those risk exposures while maintaining the yield level of their portfolio. Before the strong market rally in November 2022, the yield on a 1-year AAA was higher than the yield was on both the 30-year AAA muni and the High Yield Muni Index at the end of 2021.
Municipal Credit Quality Will Likely Peak while Defaults Should Remain Low
Municipalities weathered the COVID-induced economic shutdown, proving their resiliency by emerging from the pandemic in very strong financial positions. Municipalities came into the pandemic in strong positions as revenue growth outpaced expense growth during the 10-year economic expansion, which allowed many to build record reserve balances. Even during the pandemic, personal income, property and sales tax revenue all performed well, exceeding expectations in some cities, counties and states, while federal stimulus money and internet sales tax revenues added billions to municipal coffers.
State revenues eclipsed the previous peak and many states once again amassed reserve balances that eclipsed the record levels set in 2019. However, with an economic slowdown looming and the federal stimulus spigot about to turn off, municipal revenues and overall credit quality have likely reached a peak for the current cycle. Still, we don’t believe investors should be alarmed or fear that this will lead to a large uptick in defaults. In fact, the case for 2023 may be quite the contrary.
State Revenues Topped Pre-Pandemic Levels of 2019Source: Pew Institute
Defaults in the municipal market are rare for general government and municipal utility bond issues. Defaults that have occurred were often the result of years of financial mismanagement, poor governance and a lack of political will to make the hard decisions. Defaults have not been the result of rapidly deteriorating revenues or an economic slowdown. We anticipate that municipal defaults will remain low in 2023 but investors can expect pockets of stress to emerge. Areas that were hardest hit by COVID, such as continuing care retirement centers (CCRCs) who have been unable to attract new residents or rural, single site hospitals that suffered from the suspension of elective surgeries at the onset of COVID or from the reduction and delay of federal reimbursement payments are likely to come under pressure. Also, project finance deals that relied upon growth projections and revenue targets based on assumptions that the economic expansion would continue will also face challenges.
Investors may be wise to reduce credit risk in their portfolios to prepare for the challenges that may arise in 2023 or look to active managers with the credit research and expertise necessary to understand the covenants and avenues of recourse available for every bond they purchase.
Fund Flows, Not Supply, Will Continue to Drive the Market
The municipal market has historically been driven by technicalities and timing. Nearly half of the outstanding debt owned by households consisted of individual investors that held bonds until maturity while reinvesting a large portion of the coupon and principal payments they received back into the market. Investor behavior, coupled with market nuances such as a large portion of bond issuers making coupon payments in the months of January and July, created seasonal demand for bonds.
But that has changed. Assets have shifted from buy-and-hold investors and into professionally managed mutual funds. As a result, municipal mutual fund assets have increased from $500B to almost $1T as their ownership share of municipal debt has grown from 12% to 25%. The buyer base will continue to evolve as investors move from “do-it-yourself” portfolios to managed funds and separately managed accounts. Issuers find themselves swimming in federal COVID aid and increased tax revenue, and not needing to borrow in the municipal market. As a result decreased new issue supply has been met by increased retail demand through mutual fund flows, which has emerged as the dominate technical driver over the last several years. But this new driver (and the resulting imbalance between supply and demand), coupled with rising interest rates, has created plenty of volatility, and we expect both retail flows and accompanying volatility to continue in 2023.
Managed Funds Are Absorbing a Larger Share of Outstanding Municipal BondsManaged funds are mutual funds, ETFs and closed end funds. Crossover Buyers are banks, property and casualty insurance companies and credit unions. Source: Federal Reserve
The negative index performance in 2022 was primarily caused by rising rates but was exacerbated by retail investors pulling $125 billion out of municipal bond mutual funds. Exchange Traded Funds, in contrast, gained market share as investors took advantage of tax loss selling and moved the assets into municipal bond ETFs. As a result, municipal bond ETF assets under management grew to over $90B at the end of Q2 2022, eclipsing closed-end fund assets for the first time ever. ETFs offer advantages for investors interested in broad market exposure or a temporary parking spot, but their structure also includes risks that are unique to fixed income and municipal bonds. Primary among those risks are liquidity squeezes, which may leave ETFs trading at a discount to their net asset value.
Outflows from Mutual Funds Persisted in 2022Source: ICI
Looking forward to 2023, we expect a return to normalcy in the sense that income will be the primary driver of total return going forward for the asset class, yields will remain in more normal ranges driven by the end of the Fed’s zero interest rate policy and municipal issuers will be resilient in an economic slowdown while defaults remain rare. However, we also expect the municipal market will continue to undergo structural changes. These trends, combined with increased volatility, underscores the need for professional management in the sea of change that is the once-staid municipal bond market.
The spike in rates, while painful for bond prices, allows investors to once again earn an attractive level of tax-exempt income. The Fed remains committed to more rate hikes in 2023, however, and the inversion in the Treasury curve signals that the market believes the Fed will overshoot, tip the economy into recession and be forced to cut rates sooner than expected.
Differentiation across states, sectors and credit quality should re-emerge as investors become more discerning about the bonds they own. A central bank induced recession, along with an end to Federal stimulus dollars, could spark additional spread widening.
The municipal market is not immune to inflationary pressures but there are areas that offer some protection. Sectors that finance long-run, hard assets such as education and healthcare, or municipal utilities that operate government monopolies with inelastic demand offer desirable anti-inflationary traits.
Municipal defaults will likely remain low but may increase from 2022. Economically sensitive areas will come under pressure if the U.S. enters a recession. Areas such as healthcare, senior living facilities and project finance deals are already feeling inflationary pressures.
The municipal curve has remained very flat inside of 10-years and beyond 20-years with most of the yield pick-up between 10 and 20-years. Despite the flatness of the long-end of the curve, long maturity municipal yields look attractive on a relative basis to Treasuries.
Areas that historically offered attractive spread opportunities in the revenue space are areas of focus. However, should heightened price volatility continue, the price paid for a bond will be as important for returns as our credit research to identify specific opportunities.
City, state and county G.O. debt is attractive based on the issuer’s financial flexibility at this part of the cycle. As are essential service revenue bonds for large metropolitan areas. Pockets of opportunity exist in other sectors that offer attractive relative value and incremental income opportunities.
Absolute yield levels no longer require adding credit risk to earn an acceptable level of income. We will look to add credit on market weakness, but selectivity is paramount as is the financial flexibility of an issuer and their ability to control revenue and expenses.