2023 Municipal Bond Market Insights: Mid-year Update

Top Five Municipal Market Insights for 2023 – “Preparation Seizes Opportunity – Higher Accruals Set the Pace” 

1. Tax-exempt accrual plays a key role in total return

Rationale

Income has regained its prominence in municipal bond total return. Municipal investors can now realize much higher income accruals due to 2022’s sharp rise in rates. Top income tax bracket investors, especially those living in high income tax states, should find the higher tax-exempt income levels attractive on a taxable equivalent basis versus other asset classes. For investors in pooled vehicles, raising accrual rates tends to reward investors who reinvest their dividends through the compounding effect of buying more shares at relatively lower average prices. We believe higher income levels can also better stabilize returns compared to the last several years, when low coupons and yields offered little cushion against price declines. Additionally, we believe investors who remained in passive strategies have missed this opportunity while hoping the market would recover. Raising accrual rates required actively replacing low book yield positions with much lower priced, higher yielding bonds, trades typically known as tax swaps. We believe investors can benefit from current market accrual rates in 2023 and beyond.

Portfolio in Action

At times during the last year and a half, issuers were periodically forced to issue unusually high coupon bonds (i.e., above 5%) due to market conditions. These structures have rarely been available in the primary market in recent years.  

At key inflection points, when others were not as well-positioned to buy, we worked to secure material allotments of these attractively-structured bonds. Higher-coupon securities have helped to increase portfolio accrual rates while decreasing overall interest rate sensitivity.

Higher coupon debt may become harder to source in the primary market, especially at lower prices, as municipal bond industry fund flows come back into equilibrium.

Mid-Year Status

On Target:

• Dividend distribution rates are up, year-over-year. The average actively-managed pooled investment vehicle’s distribution is up by 26% on an asset-weighted basis. We think that investors should give more consideration to those that took the opportunity last year to reposition portfolios and improve income streams. (Source: Morningstar as of 6/30/2023)
• Do not overlook the power of compound returns for those that opt to reinvest. The potential near-term performance benefit of investing in a pooled vehicle with a higher accrual rate may be enhanced over the long run by the compounding effect of buying more shares via dividend reinvestment.
• High grade and high yield municipal bond taxable-equivalent yields of 5.95% and 9.65% compare favorably to the before-tax yields of U.S. Treasuries (4.37%), U.S. high grade corporates (5.48%), and U.S. high yield corporates (8.58%). (Source: Bloomberg as of 6/30/2023)*

2. Overweight general obligation and essential service bonds

Rationale

We believe essential investment grade sectors, such as General Obligation bonds and Water & Sewer bonds, will regain favor with investors in 2023. We expect greater demand for traditional municipal bonds such as bonds backed by the taxing power of general obligation issuers or secured by the revenues of essential service providers like public water and sewer authorities. We anticipate continued investor uncertainty over the path of inflation, the Federal Reserve’s policy decisions and the potential for a recession will be the reason why investors find comfort in the core municipal sectors. In addition, investors should favor shifting to higher quality sectors that now pay higher accrual rates. We believe core sectors of the municipal market outperform
in 2023.

Portfolio in Action

We continue to favor State and Local General Obligation bonds and essential service revenue bonds for their generally strong, resilient credit profiles. Issuers in these sectors are monopolistic in nature and their debt is often backed by dedicated or secured revenue streams.

Mid-Year Status

Pending:

• Year to date, Fitch upgraded 86 total general obligation and essential service revenue issuers, while downgrading just 13. (Source: Fitch through 6/30/23)**
• State balance sheets have improved. Aggregate rainy day fund balances more than doubled between fiscal year 2020 and fiscal year 2023 to a projected $155 billion, or 12% of median general fund expenditures. (Source: NASBO Fiscal Survey of States, Spring 2023)

Reflecting the possibility of an economic slowdown, S&P expects reserves across states to decline by an average 1.5% in 2024, compared to the 21% decline we saw during the Great Recession. (Source: S&P, April 2023)

3. In a bifurcated high yield municipal market, liquidity drives performance

Rationale

We believe a disciplined pursuit of liquidity will be rewarded in the 2023 high yield municipal market. In 2022, the massive wave of high yield fund redemptions resulted in an equally sized sell-off of bonds as funds sought liquidity. High yield municipal funds primarily sold their more widely held and better quality positions to meet those redemptions resulting in those more liquid bonds underperforming relative to holdings that did not trade throughout the year. In anticipation of a healthier market in 2023, we believe those underperforming bonds now provide the opportunity to outperform as investment discipline re-emerges. In our opinion, discipline in the high yield municipal market goes beyond credit research to include an understanding of liquidity, tradability and the investor base. We expect inflows will return to the high yield municipal market and issuance will be light. As a result, we believe the more liquid part of the high yield municipal market outperforms in 2023.

Portfolio in Action

High yield municipal industry-wide fund flows have yet to return to positive territory and are essentially flat. That said, we still favor the liquid, rated names that came under selling pressure during 2022’s liquidity squeeze. Not only can these securities benefit from eventual positive fund flows as investors buy them back, but their prices also better reflect current economic conditions. The latter point means that this subset could offer less downside risk than less-liquid, lower rated names if generic high yield market spread levels were to widen. 

Mid-Year Status

On Target:

• The BBB-rated municipal bond index, considered to be a highly liquid segment, slightly outperformed and returned 4.45% YTD 2023, while the Bloomberg High Yield Municipal Index returned 4.43%. (Source: Bloomberg as of 6/30/2023)***

Within the Bloomberg High Yield Municipal Index, larger, more liquid names were the top drivers of performance. 

4. Fund flows drive recovery in long municipal bond prices

Rationale

We believe exposure to longer-term bonds drives return in 2023. Municipal mutual funds and Exchange Traded Funds are the natural buyer of the long end of the municipal curve.  We expect a return to positive mutual fund flows results in the outperformance of longer-term bonds.  Additionally, mutual funds will likely seek to increase their distribution yields, causing them to extend the maturity and duration profile of purchases. As a result, bond structures with long durations and discount prices enhance return potential relative to shorter duration, premium structures. Finally, the Municipal to Treasury yield ratio curve remains steep, indicating that the longer end of the municipal market offers better value opportunities. Long municipal bonds with Municipal to Treasury yield ratios in the mid 90% range are cheap on a relative basis.  We believe portfolios with exposure to longer maturities outperform.

Portfolio in Action

Yield curve positioning has mattered this year. The AAA-rated municipal yield curve is inverted between two and ten years to maturity due to what we see as price-insensitive demand from SMA accounts. This area has offered little in the way of buying opportunities.  

Meanwhile, the curve has been persistently steep between ten and thirty years, still indicating that better value can be found in longer-term bonds.

Opportunistic curve positioning will likely continue to drive alpha during the second half of the year.

Mid-Year Status

Pending:

Longer-term municipal bonds outperformed shorter-term municipals through the first half of 2023. The Bloomberg Municipal Long 22+ Year Index returned 4.96%, outpacing the broader Bloomberg Municipal Index, the 1-Year Index, the 3-Year Index, and the 5-Year Index by +2.29%, +1.14%, +0.90%, and +3.77% respectively. (Source: Bloomberg as of 6/30/2023 **** 

5. Thinking outside the box – Using short taxable municipals to enhance after-tax performance

Rationale

We believe shorter-term taxable municipal bonds provide better after-tax value than comparable maturity tax-exempt bonds. Investing in shorter term municipal bonds, a tactic used to add liquidity and/or manage duration in a portfolio, becomes more difficult when these bonds are overpriced. In our view, shorter-term tax-exempt bonds have risen in price beyond fair value primarily due to passive investor demand. In 2023, we expect demand for shorter-term tax-exempt bonds to continue unabated and we do not expect that new issuance sufficiently offsets that demand. As a result, we believe shorter-term tax-free Municipal to Treasury yield ratios remain rich through the year. Comparable maturity taxable municipal yields, however, offer better value on an after-tax basis in our view. The taxable municipal market’s continuing expansion, in both size and breadth, has brought a new dimension to relative value trading in the municipal market. We believe investors should favor shorter-term taxable municipal bonds because they provide competitive after-tax yields, attractive spreads to Treasuries and the same high credit quality of the tax-exempt municipal asset class.

Portfolio in Action

Short-term taxable municipal bonds continue to provide benefits. The income advantage remains clear; these high-grade securities offer yields above comparable maturity U.S. Treasury bonds. On the other hand, AAA-rated short-term tax-exempt municipals are trading rich, only offering less than two-thirds of the yield of Treasury bonds.

Also benefitting our positions is the present supply/demand imbalance. Taxable municipal new issue supply has been limited this year, while demand has remained strong. 

Mid-Year Status

On Target:

• Short-term taxable municipals, maturing in 1-3 years, returned 1.34% YTD and have so far outperformed comparable maturity tax-exempt municipal bonds, which returned 0.90%. (Source: ICE Data as of 6/30/2023)*****