Municipal Bonds: Managing Through a Slowing Credit Cycle

This Municipal Bonds sector report is excerpted from the Second Quarter 2023 Fixed-Income Sector Views.

Municipal credit fundamentals have improved for the last three years, thanks to double-digit growth in income taxes and sales taxes, but these tailwinds are unsustainable, and we see signs that the upswing in the municipal credit cycle is nearing its end. Some states have reported a decline in tax receipts and lowered revenue estimates as a result of the cooling economy. Counterintuitively, another sign that the credit cycle is nearing its end is the recent rating upgrades for high beta states Illinois and New Jersey. High beta credits such as these are the last to get upgraded in an upcycle because of their checkered histories—volatile revenue performance, inconsistent fiscal management, rating agency skepticism, etc.—and the first to get downgraded going into a downcycle for the same reason.

Nevertheless, tax exempt municipals have started strong in 2023 after a rollercoaster ride over the last year. Tax exempts returned 4 percent year to date through mid-April and have moved into positive territory on a trailing 12-month basis. Technical support played a big role in this performance. Tax exempt mutual funds experienced outflows for most of the quarter, but these outflows were offset by a 24 percent decline in new issuance through the end of March. Municipal obligors, dealing with both record tax receipts and unspent pandemic stimulus funding, have been reluctant to access the public markets. While seasonal factors should drive issuance higher going into the summer months, those same factors also increase principal and interest payments that are reinvested in the municipal market, buffering the impact from new deal volumes. Secondary trading conditions remain orderly as there are few signs of selling pressure. For example, dealer holdings of bonds maturing beyond 10 years have declined 25 percent versus the prior year and stayed well below the five-year average for most of the last 12 months. Bid wanted volumes—a barometer for mutual fund liquidity needs—declined by as much as 52 percent year-over-year during some days in March and April.

Due to positive technical support, the ratio of tax-exempt yields to Treasury yields has stayed rich—for example, the 10-year ratio is 68 percent, the low end of the 12-month range of 60–105 percent. Amid signs of a slowing credit cycle, we advise caution. In this environment, tax exempt investors should remain focused on reducing negative convexity while upgrading into higher-quality bonds.

—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.

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