Given the backdrop of both geopolitical tensions and changing monetary policies at a global level, we have seen elevated volatility in both the fixed income and equity markets since the beginning of the year. In response, we wanted to share our thoughts on the investment opportunity at hand in the US taxable municipal market. As discussed in our Top Five Municipal Insights, MacKay Municipal Managers expected heightened market volatility in anticipation of the Federal Reserve’s policy actions in 2022. And, as active relative value managers, we see these bouts of volatility as attractive investment opportunities.
With this in mind, where appropriate, we intentionally manage our client portfolios to be prepared to pivot and capitalize in these types of market environments. Exposure to taxable municipals already comes with the added benefit of serving as a counter weight to inflation concerns, which is one of the main catalysts for the volatility markets are experiencing. Municipal enterprises can more easily raise prices or fees on consumers to combat rising inflation costs. Inflation concerns have not spared taxable municipal markets, but at their core, taxable municipals should be somewhat insulated from these concerns, and the current market environment is providing an opportunity to add exposure at levels that seem to disregard this strength. We believe this is a great opportunity to add exposure to taxable municipals, which for the reasons we pointed out, should outperform other investment grade fixed income markets for the eleventh consecutive year.
1) Higher Book Yields
Bonds are trading at attractive book yields across the curve. Figure 1 shows yield differential between what we were seeing in the market at the beginning of January vs. now.
As the curve has continued to flatten, we are seeing more opportunity down the curve specifically inside the 10 year where we are able to pick up additional yield. In some cases, yields are close to 3.25% - 3.50%. Additionally, positioning portfolios with lower duration, and diversified curve exposure can assist as rates move higher and can allow us to participate if the yield curve begins to steepen.
Figure 1: AAA Taxable Yields
Even though the front end of the curve is rising with rising hedging costs, in our view net hedged yields are still attractive.
Figure 2: Net Yield to Worst (EUR)
Figure 3: Net Yield to Worst (JPY)
2) Volatilty Can Create Opportunity
Although we expect more volatility in the market over the next coming months as the Federal Reserve moves forward with its first rate hike in the US, we believe the majority of the rate hikes expected in 2022 have been priced into the market already. The unknowns in this cycle remain inflation, the unwinding of Quantitative Easing and the reduction of the Federal Reserve’s balance sheet. These factors may potentially determine the shape of the yield curve for the remainder of the year and will present the market with continued volatility, and opportunities.
3) Credit Fundamentals Intact
Our view is the fundamentals of taxable municipal credits remain sound and we expect growing investor demand for high quality, monopoly-like municipals where issuers have the ability to raise taxes and user fees on their essential services. This allows issuers to maintain adequate debt service coverage, stabilizes credit ratings and reduces bond price sensitivity to rising rates and higher inflation. Furthermore, we believe active management with tactical trading in these volatile periods should create alpha opportunities for the remainder of 2022. In this current environment, we will continue to maintain some cash and liquidity in portfolios to take advantage of these opportunities, and would welcome any additional capital allocations.
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