Municipal Bonds: Muni Volatility Overshadows Strong Sector Fundamentals
Munis represent an opportunity for tax-averse investors to generate long-term income streams.
Technical factors continued to dominate the municipal market through the second quarter, during which tax-exempt munis declined by 2.9 percent, taking year-to-date returns as of June 30 to -8.98 percent. Taxable munis returned -6.2 percent in the second quarter and -14.0 percent year to date.
Tax exempt munis faced a buyers’ strike for most of 2022, as fears over inflation prompted mutual fund outflows totaling $77 billion—on pace to exceed previous totals for full year 2021. Despite a manageable new issue supply of $166 billion as of June 30, 2022, just 3 percent less than the same period last year, funds have had to sell positions to meet redemptions. Consequently, the market’s less-liquid segments, including sub-5 percent coupon bonds and high-yield, have materially underperformed other sectors. A brief respite came in late May, when municipal/Treasury yield ratios reached 12-month highs and a couple of large deals cleared the market at attractive spreads, drawing in crossover buyers. However, the selloff resumed as rate volatility returned, with tax exempts down 1.8 percent in June.
Taxable municipals suffered worse returns than tax exempts this year due to their longer duration, and their spreads widened in conjunction with other credit sectors. As of June 30, index-eligible taxables still trade tighter than corporates, as year-to-date issuance volumes dropped 45 percent versus 2021.
Performance aside, municipal credit quality remains strong. Upgrades consistently outnumber downgrades, and defaults are low. At the state level, rainy day funds are expected to remain high for fiscal year 2023 despite lackluster revenue expectations, as states draw down funds from the American Rescue Plan.
In our view, tax-exempt investors should focus on liquid structures, such as callable 5 percent coupon bonds, ideally with a non-call period beyond five years to minimize the negative convexity profile. Tax averse, income-oriented investors should consider allocations at current market levels, despite municipal/Treasury ratios having recovered from their one year wides. While 10-year ratios hover around 91 percent, the 2.7 percent yield on 10-year AAA munis is in line with late March 2020, when ratios hit a record high of 370 percent. Municipal credits are bespoke and trade mostly by appointment, so we believe investors should view the sector as an opportunity to lock in satisfactory income over time rather than waiting for short-lived turning points like late May 2022.
10-Year AAA Muni Yields Mirror March 2020, When Muni/Treasury Ratios Peaked
Source: Guggenheim Investments, The Municipal Market Monitor (TM3). Data as of 6.30.2022.
—By Allen Li and Michael Park
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