/perspectives/sector-views/municipal-bonds-differing-values-taxable-vs-exempt

Municipal Bonds: Differing Values in Taxable vs. Tax Exempt Munis

Avoid negative convexity in tax exempts, and in taxables focus on value in non-indexed securities.

November 10, 2022


This Municipal sector report is excerpted from the Fourth Quarter 2022 Fixed-Income Sector Views.

With the rise in Treasury yields continuing to dominate the fixed-income market in the third quarter, Bloomberg Municipal Bond Index Total Return Index returns fell 3.5 percent for the quarter, bringing returns to -12.1 percent year to date as of Sept. 30, while Bloomberg Municipal Index Taxable Bonds Total Return Index returns declined 6.2 percent for the quarter and -19.3 percent year to date. Taxable municipals underperformed tax exempts due to their longer duration.

Tax exempt mutual funds faced outflows for most of the quarter, and year-to-date redemptions exceeded $100 billion—higher than any previous full year total. However, we suspect that there has been a slow reversal of this trend as the two largest municipal ETFs began experiencing consistent inflows near the end of the quarter. Tax loss swapping likely drove this activity, as investors realized losses on their mutual funds before rolling the proceeds into ETFs in order to maintain exposure to the muni market and gain intraday liquidity. Combined with an anemic new issue calendar, ETF activity depressed muni/Treasury yield ratios. Taxable muni spreads widened in conjunction with other credit sectors, but as of the end of the third quarter, index-eligible (i.e. investment grade) taxable munis traded at tighter spreads than investment-grade corporate bonds as year-to-date issuance volumes declined 48 percent compared to the same period last year.

Municipal bond credit quality remains strong: States’ rainy-day funds are expected to stay high for fiscal year 2023, and American Rescue Plan funds have yet to be fully spent. However, municipalities with a higher proportion of market-sensitive revenues, such as capital gains taxes, have started missing top-line forecasts. This portends possible challenges in the 2023–24 budget season.

Tax exempt muni investors should focus on reducing negative convexity, which causes bonds to underperform in most rate scenarios. For example, products such as 5 percent coupon bonds with very short par call dates give issuers the option to call if rates fall but stick investors with rate volatility if rates rise. On the taxable side, while index-eligible bonds are trading at tighter spreads than investment-grade corporate bonds, non-index paper remains relatively attractive. Differences in liquidity between index- and non-index securities have narrowed amid current market volatility.

Taxable Muni Spreads Tighten Relative to Corporates

Taxable muni spreads widened in conjunction with other credit sectors, but as of the end of the third quarter, index-eligible (i.e. investment grade) taxable munis traded at tighter spreads than investment-grade corporate bonds as year-to-date issuance volumes declined 48 percent compared to the same period last year.

Taxable Muni Spreads Tighten Relative to Corporates

Source: Guggenheim Investments, Bloomberg, data as of 10.18.2022. OAS - option-adjusted spread.

—By Allen Li and Michael Park

 
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Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-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 risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Municipal bonds may be subject to credit, interest, prepayment, liquidity, and valuation risks. In addition, municipal securities can be affected by unfavorable legislative or political developments and adverse changes in the economic and fiscal conditions of state and municipal issuers or the federal government in case it provides financial support to these issuers.

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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 Partners Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC.

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