Summary
- Municipal bonds posted historically strong total returns in January, amid rallying interest rates.
- Light issuance and improved demand spurred outperformance versus comparable Treasuries.
- Waning seasonal tailwinds and potential for added volatility warrant some near-term caution.
Originally published on February 8, 2023
Market overview
Municipal bonds posted their second-best start to the year in over 30 years, trailing only the bounceback from the Global Financial Crisis in January 2009. Strong performance was driven by improved supply-and-demand dynamics and rallying interest rates, amid expectations that the Federal Reserve (Fed) will pause monetary policy tightening in early 2023. The S&P Municipal Bond Index returned 2.82% and considerably outperformed comparable Treasuries. Longer-duration (i.e., more sensitive to interest rate changes) and lower credit-quality bonds performed best. The asset class has now garnered total returns of 7.61% over the past three months.
Issuance remained subdued at just $23 billion, or 12% below the five-year average, and was outpaced by reinvestment income from maturities, calls, and coupons by over $5 billion. At the same time, tax loss-driven outflows ended at the turn of the year, and the asset class accumulated $3.9 billion in net inflows in January. Despite rich valuations, attractive dollar prices and favorable taxable-equivalent yields kept retail investors engaged. As a result, selling activity fell 36% month-over-month to just over $1 billion per day on average.
Given the outsized total returns harvested in January, we have shifted to a slightly more defensive posture and are looking to monetize gains as seasonal trends turn less favorable in February. While we anticipate that supply-and-demand technicals will remain supportive, we expect heightened volatility throughout early 2023 in both interest rates and performance as the Fed tries to engineer a soft landing.
Strategy insights
We prefer a slightly short duration stance and are reducing portfolio durations. We maintain an up-in-quality bias overall, but we are adding to our high yield allocation to take advantage of the favorable risk-reward profile offered by discount 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 highest quality state and local issuers with broadest tax support.
- Flagship universities and diversified health systems.
- 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.
Credit headlines Moody’s reported that delinquencies in the fourth quarter of 2022 rose in the non-rated segment of the municipal market, reversing the downward trend experienced earlier in the year. Unlike the rated universe of municipal bonds that are primarily backed by defensive tax revenues and user fees for essential services, credit risk is much higher for non-rated issuers that are subject to competitive pressure and are vulnerable to changes in economic conditions. The spike in delinquencies is not surprising, with most of the problems concentrated in senior living facilities and small healthcare providers dealing with labor costs, as well as stand-alone projects that experienced cost overruns and construction delays. Looking past the headlines, defaults in municipals remain rare with only 0.1% of all issuers defaulting in 2022. With the probability of a U.S. recession increasing, credit deterioration across the municipal market increases the potential for downgrades. However, default risk will remain concentrated in a limited segment of the high yield market.
A spike in municipal credit spreads should be viewed as an opportunity, and maintaining a diversified portfolio with strict issuer limits remains the optimal strategy when investing in high yield municipals.
Municipal and Treasury yield movements
Municipal performance
This post originally appeared on the iShares Market Insights.
For further details see:
Municipals Off To A Fast Start In 2023