FMNY - Patience And Caution - Watchwords For A Bounce Back 2023

Summary

• When rates increase, prices decline: the broad muni market, as measured by the Bloomberg Muni Bond Index, fell ?8.53%.
• While we expect 2023 to be a bounce back year, we don’t foresee the historical 13% average bounce back that has occurred after past negative return years.
• We expect fund flows will be mixed during the first quarter, but flows should firm up as the Fed moderates its rate hiking pace.
• Caution and patience are once again the key watchwords for 2023, just as they were in 2022.

2022 was the worst year for muni performance in over 40 years

Unprecedented inflation levels following the COVID-19 pandemic spurred a historically aggressive Fed tightening cycle in 2022. Seven consecutive rate hikes led to the fed funds rate increasing from 0– .25% to 4.25–4.50% by year-end. Muni yields increased anywhere from 233 basis points in the front end of the curve to 208 bps on the long end of the curve. When rates increase, prices decline: the broad muni market, as measured by the Bloomberg Muni Bond Index, fell ?8.53%.

Yields are again attractive & offer greater income

Inflation will prove sticky

Looking ahead, we believe the peak in U.S. rates is behind us, but we anticipate that inflation will be more persistent than the market is currently pricing. Thus, the Federal Reserve (Fed) will likely keep the fed funds rate elevated throughout 2023, while economic growth remains positive but slow. We are still a long way from the Fed’s target inflation rate of 2%.

2023 a bounce back year

Market participants tend to believe a huge down year will be followed by a strong up year (known as a reversion to the mean)—and history suggests this is usually true. However, while we do expect 2023 to be a bounce back year, we don’t foresee the historical 13% average bounce back that has occurred after past negative return years. We do not believe that the market can produce that level of returns in 2023 if the Fed remains active, thus we urge patience and caution during the first quarter of 2023, and perhaps throughout the first half of the year. If the second half of 2023 shows the anticipated market strength, we could then foresee mid-single-digit total returns of 4–6% for the Bloomberg Muni Bond Index for the year.

Bounce back year, just less so…

Pent-up demand strong, pointing to increased gross issuance

Retail investors will bolster demand for short and intermediate munis, as they continue to prefer individual bonds at more attractive dollar prices and are more concerned with all-in yields rather than rich valuations. Demand for the long end of the curve may take a bit longer to materialize. However, if investors turn bullish on duration (likely Fed related), then that could have an immediate impact on the market.

We expect fund flows will be mixed during the first quarter—perhaps even through the first half of the year—but flows should firm up as the Fed moderates its rate hiking pace. Still, it will take multiple years to make up for the outflows seen in 2022; we believe the market will recapture a quarter to a third of the 2022 outflows in 2023.

We expect a 14% year-over-year increase in issuance to $400 billion, given our expectation that pent-up demand will bring issuers back into the market as stimulus dollars dry up, delayed projects are resurrected, and the interest rate backdrop improves later in 2023. Our forecast is on par with Street consensus, which calls for issuance ranging from $350-500 billion, averaging $409 billion. Last year deviated from the traditional seasonal pattern of issuance, given the poor performance for munis and the outflow cycle which followed. Structurally, we expect a return to a more traditional pattern of issuance in 2023, with supply slightly more back-end loaded. There will still be net-negative issuance, which is a positive technical in a more balanced market, as maturities, calls, and coupons (assuming a 65% reinvestment rate) are expected to outpace issuance by about $21.5 billion. We anticipate taxable munis will total approximately 15% of total supply, off their peak of 31% in 2020.

Historic rout

Up-in-quality strategy for 2023

Caution and patience are once again the key watchwords for 2023, just as they were in 2022. Munis continue to play an important role in any diversified portfolio, and the steady nature of their tax-exempt income and high credit quality remain the cornerstone of the muni market.

We prefer an up-in-quality bias overall, finding the best value among bonds in the 15–20-year part of the curve where investors can pick up 90?95% of the curve, without having to take on additional duration risk. In addition, taxable-equivalent yields are currently above 5%, and muni ETF demand is strong for that segment of the curve. For investors looking to stay short, U.S. Treasuries and investment grade credit currently offer better value.

As the economy slows, we expect increased performance disparity among market segments. Although discounted dollar prices for high yield bonds appear attractive, we emphasize that security selection will be a key driver of returns in the high yield space in 2023.

Credit views for 2023

Supportive municipal fundamentals. Although the peak in the credit cycle has likely been reached, municipal fundamentals remain on solid ground. Surplus revenues and unprecedented federal aid have allowed states to accumulate reserves, retire debt, and fortify pensions. Lower revenues, higher borrowing costs, and poor investment returns will pressure 2024 budgets; however, excess reserves and limited capital needs provide near-term flexibility, while higher interest rates allow states to de-risk pension plans. Local governments and school districts that rely primarily upon property tax revenues have historically fared well during a recession, although stagnation or declines in housing values make tax hikes more unpopular. Rising wages for workers will be one of the largest pressures on state and local budgets. However, depending on the severity of any recession in 2023, wage pressures could moderate.

Focus on investment grade ‘safe havens.’ Our best thoughts for the state and local government sectors center around high-quality credits and regions exposed to energy and commodities. We also prefer local governments in regions benefiting from the shift in demographics and attracting ‘new economy’ jobs. Broad-based state and countywide sales tax bonds offer ample coverage and are not exposed to the operating risk of their respective governments. Essential service providers (public power, water & sewer, and transportation) that possess rate-setting autonomy to pass costs on to consumers are safe havens in a downturn. However, caution is warranted in sectors subject to competitive pressures such as health care and education. Hospitals can be acquisition targets, although there are few buyers for stand-alone, rural providers that struggle with margins and attracting qualified nurses and physicians. Caution is also warranted for small, private universities in the Northeast and Midwest dealing with a shrinking pool of graduates and relying heavily on discounts to attract students.

Prospects for high yield. Fundamentals remain positive for most sectors. Tobacco bonds benefit from the inflation adjustment (under the 1998 national settlement with major tobacco companies), offsetting declines in tobacco consumption. Tax collections in Puerto Rico continue to outperform. Increasing property taxes provide stability for charter schools. Airlines are flush with cash, and business travel is normalizing. While defaults remain episodic and concentrated in a handful of spaces, we anticipate a modest uptick in 2023, with continued stress in senior living, early-stage land developments, and stand-alone projects based upon overly optimistic projections. We foresee headline risk surrounding several high-profile issues that are dramatically underperforming projections, but any contagion should be viewed as an opportunity for bargain hunters. We are more constructive on the asset class compared to 2022, given that most high yield bonds are now priced at a discount, offering a better risk-reward profile.

Municipal discount bonds (priced below par)

This post originally appeared on the BlackRock Blog.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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