BSMT - Munis Retreat Amid Rising Interest Rates In February

2023-03-08 06:30:00 ET

Summary

• Municipal bonds posted negative total returns and modest underperformance versus Treasuries.
• While supply remained manageable, demand waned as performance turned negative.
• We maintain a defensive posture given our expectation for continued interest rate volatility.

Market Overview

Municipal bonds posted sharply negative total returns in February, erasing 83% of their historic gains to start the year. Rising interest rates weighed heavily on the market as strong economic data spurred expectations for a longer Federal Reserve (Fed) tightening cycle and a higher terminal rate. The S&P Municipal Bond Index returned -2.33%, bringing the year-to-date total return to 0.43%. Rich valuations resulted in modest underperformance versus comparable Treasuries. Shorter-duration (i.e., less sensitive to interest rate changes) and single-A-rated bonds performed best.

Issuance trended well below seasonal expectations at just $20 billion, 31% below the five-year average, bringing the year-to-date total to $43 billion. Supply was outpaced by reinvestment income from maturities, calls, and coupons by nearly $16 billion, which helped contain the magnitude of underperformance as rates rose. At the same time, fund flows decelerated as performance turned negative, and robust inflows starting the month turned to moderate outflows by month end. As a result, bid-wanted activity picked up, and new issue oversubscriptions moderated to just 2.1 times, on average, from 4.3 times last month.

We uphold our defensive posture as we enter the less seasonally favorable month of March. Although issuance is expected to remain manageable, continued interest rate volatility will pressure demand and could force further deleveraging. Additionally, historically rich valuations provide limited opportunity for material outperformance going forward. As such, we maintain that caution and patience will likely be warranted throughout the first half of 2023, or until the future path of Fed policy is better understood.

Strategy insights

We favor a short-duration posture and are continuing to reduce portfolio durations. We prefer single-A-rated credits, the 15–20-year part of the yield curve, and a neutral allocation to non-investment grade bonds. We like regions exposed to energy and commodities, local governments benefiting from changing demographics, and essential service providers.

Overweight

• Essential-service revenue bonds.
• Select the highest quality state and local issuers with the broadest tax support.
• Flagship universities.
• Select issuers in the high-yield space

Underweight

• Speculative projects with weak sponsorship, unproven technology, or unsound feasibility studies.
• Senior living and long-term care facilities in saturated markets.
• Lower rated private universities
• Stand-alone and rural health providers

Credit headlines

Citing greater budgetary flexibility and stability, accelerated repayment of liabilities, and a higher budget stabilization fund, S&P upgraded the State of Illinois’ credit rating to ‘A-’ from ‘Baa1’, the highest level since 2016. The upgrade followed Gov. Pritzker’s $49.6 billion executive budget proposal for FY 2024 (starts July 1). The budget adds $138 million to the state’s budget stabilization fund, projected to end FY 2024 at $2.1 billion, and contributes $9.8 billion to its underfunded pension plans. Illinois has received multiple agency upgrades over the last few years, as the state also benefited from emergency federal aid and own-source revenue growth in a strong post-COVID-19 economic recovery.

New Jersey Gov. Phil Murphy’s FY 2024 budget calls for $53.1 billion in spending, almost 3% less than the current FY 2023 adjusted budget, and roughly the same level of total revenue. The budget includes a $10.0 billion ending surplus balance, the highest in the state’s history, and a $7.1 billion pension payment, the third-consecutive full pension contribution in 25 years. With ‘positive’ outlooks from all three major rating agencies, the state is well positioned for additional upgrades to its current GO bond ratings (A2/A-/A).

Municipal and Treasury yield movements

Municipal performance

This post originally appeared on the iShares Market Insights.

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