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Interest Rates

Municipal Bonds: Earning Their Way Out Faster

Eve Lando, JD
Portfolio Manager and Managing Director
17 May 2022
2 min read

Municipal bonds suffered a sharp sell-off through the early part of 2022, but this segment often recovers more quickly and stronger than may be expected.

Rising Rates and Sliding Munis 

Municipal bonds represent a sliver of the global and domestic fixed income market, but as we’ve noted before, this asset class has structural characteristics that separate municipal bonds from other securities. One such characteristic is that municipal bonds broadly have more interest rate risk than other fixed income assets such as corporate securities. As a result, the municipal bond market has historically been an interest rates driven market and not a credit market.

Municipal bonds finance most of the education, infrastructure and health care in the country and these assets, e.g., water and sewer systems, school buildings, hospitals, bridges, roads and tunnels, have long lives and are financed for longer periods. Using BB indexes average maturities, the municipal index comes in at 12.8 years and U.S. corporate index closer to seven years. This longer duration profile often leads to a more pronounced sell-off as interest rates rise.

Historically, Municipal Bonds Have Rebounded Smartly Following Sharp Declines

Apart from rising rates, there are other factors that contribute to the more pronounced sell-off that occurs in municipal bonds. Liquidity. The municipal bond market is much less liquid than corporates and other fixed income security markets, with both daily trading volumes and new issue supply well below their corporate counterparts. The municipal bond market is also dominated by retail investors seeking tax-free income streams. Consequently, this leads to outflows when there should be inflows and vice versa. Additionally, there are far less buyers of last resort that would normally step in during periods of volatility, such as broker dealers or banks and insurance companies.

Recovery as Usual?

Municipals may exhibit an initial sell-off that is worse than other parts of the market, but this segment of the fixed income market often recovers more quickly and stronger than may be expected. There are several key contributors to these post-rate-rise recoveries. Municipal bonds have a higher average coupon than other fixed income instruments, which allows the asset class to ‘earn’ its way out of the market drop. Duration in fixed income is the expected principal increase or loss given a 1% move in interest rates but to arrive at the expected total return the security’s income stream needs to be added to the equation. Only coupon income derived from municipal bonds is tax exempt. For that reason, issuers go to market with higher coupon bonds which benefits the investor.

Along with the higher coupon, the retail dominance of the market often leads to selling that begets itself creating a vicious cycle of negative performance. We believe the key is to hold or add to municipal bond positions during periods of pronounced outflows, buying yield at much cheaper levels to increase the income of an investor’s portfolio as is the case today.

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