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    Municipal bonds: Window of opportunity

    Municipal bonds: Window of opportunity

    May 09, 2022 Fixed income

    A perfect storm of muni underperformance has create a window of opportunity. We believe investors should seriously consider taking advantage of it.

    Contents

    Executive summary

    • Munis sell-offs have been rare, and have historically been followed by strong rebounds
    • Technicals are reversing, creating a window of opportunity to access cheaper valuations
    • Munis offer a measure of inflation protection and have historically performed well when rates have risen
    • Muni fundamentals look particularly strong, with many states having spent only a fraction of their pandemic-era fiscal support

    Munis have suffered a perfect storm

    The start of 2022 has been a “perfect storm” for the muni market. The Federal Reserve’s “hawkish pivot”, inflationary pressure and uncertainty driven by the Russian invasion of Ukraine contributed to uncertainty across all fixed income assets.

    The result has been the heaviest net outflows since the onset of the pandemic in 2020 (Figure 1). The volume of munis out for bid in early April 2022 surpassed $2bn1, new highs for the year. This was in stark contrast to a stream of almost continuous inflows over the year prior.

    Figure 1: Muni fund outflows have been the heaviest since the start of the pandemic2

    Muni fund outflows have been the heaviest since the start of the pandemic

    This has occurred during continued heavy issuance. Issuers have sold more than 10 deals of a billion dollars or more so far in 2022 and are on pace to beat the record of 26 set in 2020 . Even those huge budget surpluses have come to market, putting further downward pressure on prices.

    This has created a window of opportunity for investors

    These types of sell-off have been rare in muni history. When they have happened, the market has consistently rebounded strongly, with inflows sharply rebounding (Table 1).

    Table 1: Similar drawdowns have preceded record rebounds3

          Cumulative recovery post-drawdown
    Drawdown start date Drawdown end date Drawdown 1-year return 2-year return
    Mar-04 May-04 -5.29% 8.96% 10.89%
    Jan-08 Oct-08 -11.12% 19.89% 29.28%
    Oct-10 Jan-11 -6.46% 15.20% 21.84%
    May-13 Sep-13 -6.77% 10.36% 13.40%
    Jul-16 Dec-16 -5.71% 6.37% 7.20%
    Mar-20 Mar-20 -10.94% 13.29% 9.17%
    Aug-21 May-22 -9.38% ? ?

    We expect a potentially similar trajectory, particularly as technicals are set to reverse by the summer.

    From a supply perspective, $39bn of munis are scheduled to mature in June, followed by $35bn in July and $36bn in August3. Further, we expect $5bn to $10bn of calls each month. Supply has potentially been front-loaded as many issuers sought to get ahead of rising interest rates this year. Still, the tax-exempt muni market is forecast shrink by $40bn in 20224.

    From a valuation perspective, muni yield ratios to Treasury yields are increasingly attractive as they are now at their cheapest levels since the start of the pandemic, at close to neutral (Figure 2).

    Figure 2: Muni ratios have cheapened5

    Muni ratios have cheapened

    Further, taxable muni yields currently offer a 35bp yield pickup over AA rated US corporate bonds6. Meanwhile, European investors can benefit from a currency-hedged ~125bp pickup over AA euro sovereign debt and a ~80bp pickup over AA European corporate debt7.

    Investors still have substantial cash on the sidelines, with balances in US money market funds still ~$1trn higher than pre-pandemic, waiting for entry points such as these (Figure 3).

    Figure 3: Investor cash is waiting to be put to work where yields are compelling8

    Investor cash is waiting to be put to work where yields are compelling

    Munis may also offer an opportunity to defend against rising rates and inflation

    Municipals have tended to outperform Treasuries during rising rate environments (Figure 4).

    Figure 4: Munis have tended to show positive excess returns when rates have risen9

    Munis have tended to show positive excess returns when rates have risen

    Historically, during rising rate periods, retail investors have sought shelter in municipals to benefit from higher tax-exempt interest rates. Further, supply tends to fall as municipalities prefer to avoid raising debt at higher rates.

    Municipals can also offer a measure of inflation protection. Municipalities benefit from increased tax collections (such as sales tax) from higher prices during periods of strong economic growth. The strong performance of the housing market across the US also offers the potential for municipalities to see higher income from property taxes.

    Further, many revenue bonds are tied to essential services projects such as power generation, where energy costs are being passed onto businesses and consumers. Additionally, structures such as tobacco master settlement agreement (MSA) bonds have their revenues directly tied to inflation.

    Municipals have compelling fundamentals in our view

    The recent volatility in municipals has not been related to fundamentals. From a debt service perspective, we believe that municipals are in excellent shape, particularly following several stimulus programs from the Federal government including the American Rescue Plan (ARP).

    For example, New York state has only spent $10bn of the $26bn they received under the ARP, and only currently plan to spend a further $12.75bn, after which it will still have funds left over. Most states are in similar positions.

    Further, given the Administration’s sanctions on Russian energy, energy producing states (such as Texas, New Mexico and North Dakota) stand to benefit from direct taxes and second round effects of rising revenues to local economies. Alaska may also see $1bn in unexpected revenue from higher oil prices.

    The airport sector has received a fundamental credit boost with air travel recovering close to pre-pandemic levels. We believe the rebound is set to continue as demand is expected to increase throughout the peak spring/summer travel season although higher energy prices may curtail future travel activity.

    Municipal rating activity during 2021, according to Moody’s, was the most positive rating year since 2007 and the 10th strongest since 1989 with its upgrade to downgrade ratio at 2.7 to 1 (Figure 6).

    Figure 5: Municipal fundamentals are some of the healthiest in fixed income in our view10

    Municipal fundamentals are some of the healthiest in fixed income in our view

    Conclusion: Take advantage of the window of opportunity

    We believe that the perfect storm of municipal bond underperformance has delivered an excellent opportunity for investors to consider entering the asset class, particularly before supply materially falls over the summer.

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