/institutional/perspectives/sector-views/municipal-bonds-cracks-form-in-muniland

Municipal Bonds: Cracks Form in Muniland

Wary of a slowing credit cycle and waning technical tailwinds.

August 21, 2023


This Rates sector report is excerpted from the Third Quarter 2023 Fixed-Income Sector Views.

While credit fundamentals remain solid for historically stable municipal bond sectors such as state governments and essential utilities, individual income tax revenues have come under pressure due to a falloff in capital gains taxes, causing multiple states to experience year-over-year declines. The median rainy day fund for all 50 states is expected to reach 13.5 percent of budgeted expenditures for the current fiscal year, which began on June 1 for most states, up from 12 percent for the prior fiscal year. However, some cracks have appeared in the riskier sectors of the municipal market: Defaults totaled $958 million through May, 58 percent higher than last year. Defaults were dominated by two sectors, with parking facilities comprising 42 percent of the total, and nursing homes, where the operational impact of COVID has continued to work through financial statements, comprising 30 percent of the total.

Technical tailwinds have allowed tax exempt municipals to maintain returns in 2023—2.1 percent year to date through mid-August—despite rate volatility. Tax exempt mutual funds experienced outflows for most of the second quarter, but these outflows were offset by a decline of 14 percent in new issuance through early August. The period between June and August is expected to experience the largest net supply deficit for the year due to significantly larger principal and interest (P&I) payments than the rest of 2023, which typically get reinvested in the muni market: $47 billion average P&I payments during those three months versus $32 billion average payments for the remaining nine months of a 12-month period.

The overwhelming net cash flows have sufficiently offset slowing secondary trading conditions. Bid wanted volumes—a barometer for mutual fund liquidity needs—are 14 percent higher year over year. Dealer inventories maturing beyond 10 years have increased 21 percent versus 2022, and are 19 percent above their rolling one-year average. Due to the net supply deficit, the ratio of tax exempt yields to Treasury yields has stayed rich—the 10-year ratio is 65 percent, at the low end of the 12-month range of 60–89 percent. However, we advise caution amid signs of a slowing credit cycle and waning technical tailwinds: The influx of P&I payments drops down to just $28 billion per month on average from September to November. Combined with rich current valuations and reduced secondary market liquidity, we expect tax exempt returns to weaken from the latter half of the summer through the start of the fourth quarter.

Dealer Inventories Maturing Beyond 10 Years Have Risen

Dealer Net Positions Maturing 10+ Years Relative to Rolling 1-Year Average

Slow secondary market activity and fading technical tailwinds for tax exempt municipals have led to a 21 percent increase in dealer inventories maturing beyond 10 years. We believe these factors, in addition to rising defaults, will lead to weaker tax exempt returns through the start of the fourth quarter.

Dealer Inventories Maturing Beyond 10 Years Have Risen

Source: Guggenheim Investments, Federal Reserve Bank of New York. Data as of 6.30.2023.

—By By Allen Li and Michael Park

Important Notices and Disclosures

This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.

This material contains opinions of the authors, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward-looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.

Investing involves risk, including the possible loss of principal. Investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their values to decline. High yield and unrated debt securities are at a greater risk of default than investment grade bonds and may be less liquid, which may increase volatility. Investors in asset-backed securities, including mortgage-backed securities and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-backed securities may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.

Guggenheim Investments represents the following affiliated investment management businesses: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Partners Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.

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© Guggenheim Investments. All rights reserved.

Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, and GS GAMMA Advisors, LLC.