Technical headwinds create a silver lining for municipal bonds

Like most areas of the bond market, municipal bonds have been under considerable pressure throughout the course of this year. Inflation has proven to be stickier than previously thought, spurring the U.S. Federal Reserve to embark on its most aggressive tightening cycle in decades, shifting bond rates across the curve sharply higher than they were at the start of this year.

This rise in yields has caused a spate of negative performance for the municipal bond space and investors within the asset class are understandably nervous. As of the end of October, the drawdown in the Bloomberg Municipal Bond Index has reached -10.83%. By comparison, this drawdown is larger than that experienced during March 2020 as pandemic fears weighed on the markets, or even in 2008 during the global financial crisis. 

Higher yields and the resulting performance woes have caused an unprecedented outflow cycle for the municipal market. While monthly net flows into municipal bonds historically tend to be steadily positive, the municipal market has been beleaguered by a streak of negative flows that has persisted throughout the year. 

Net outflows have created technical headwinds for the municipal market, particularly for mutual fund managers who might be forced to sell positions to meet investor redemptions. This period of market stress has also created a potential opportunity for investment managers that can take advantage of this opportunity, especially as the fundamentals for municipal bonds remain strong.

Munis attractive relative to Treasuries

While municipal bonds and Treasuries have both been subject to pressure from rising rates this year, the muni/Treasury ratio can be a useful tool to ascertain the relative value between the two areas of the bond market. This ratio compares the yields on an index of AAA-rated municipal bonds versus the yield on the equivalent Treasury note: The higher the ratio, the more attractive municipal bonds are relative to Treasuries.

Over the long term, muni bond/Treasury ratios tend to hover around 75% to 85%. Early in the year, this ratio spiked higher, even moving above 100% in May for some of the longer duration areas of the municipal bond market.

Though the ratio has fallen for some parts of the market, investors who haven’t yet added an allocation to municipal bonds can still take advantage of this relative value opportunity. The metric has moved sideways for much of the year and remains above long-term averages, signaling that municipal bonds remain attractive on a relative basis to Treasuries.

Record tax revenues for many municipalities

After declining early in the pandemic, many state and local governments have now seen their tax revenues rise to record levels, creating budget surpluses across the country that have enabled municipalities to make long-needed improvements and grow their financial cushions in order to withstand the next period of economic uncertainty.

Federal aid, such as that provided by the Coronavirus Aid, Relief, and Economic Security Act and the American Rescue Plan Act, helped to prop up state and local funding. But consumers’ marked shift from spending on services to goods during the pandemic also gave an unexpected bump to tax collections, as services are usually exempt from sales tax. Local governments also tend to receive a large portion of tax revenue from property taxes, which have seen benefit from surging home prices around the country.

Municipal bonds in a recessionary environment

Our research shows that higher-quality bonds such as municipals have historically tended to do well in late-cycle environments like the one we currently find ourselves in. Should the economy tip into a recession, a scenario that seems to be more and more likely, municipal bonds should continue to hold up well.

According to data from Moody’s Investors Service, a credit rating agency, municipal bonds tend to have more stable ratings and experience a lower incidence of defaults relative to corporate bonds.

Corporate bonds have a higher percentage of defaults relative to a comparable municipal bond across all credit ratings ranging from AA to Caa-C.

Municipal bonds also tend to transition between credit ratings less often than corporate bonds. Rating transitions, particularly downgrades, can have a significant negative impact on a bond’s price. This means that municipal bonds’ tendency to avoid ratings drift, even during recessionary periods, may provide a level of stability for investor fixed-income portfolios even in challenging market environments. 

A silver lining for investors

With yields at their highest levels in over a decade as well as a strong fundamental backdrop for the space, we believe that the technical headwinds that have beset municipal bonds over the past year have a silver lining: compelling valuations within an asset class that seems well positioned for a potentially difficult market environment ahead. Investors who are worried about capital preservation in the face of a recession should consider whether municipal bonds deserve a place within fixed-income portfolios.