The quarter began strong as the fixed income asset class offered attractive value relative to its counterparts. In stark contrast there was weak performance in February. This was due to employment numbers and other economic data points that came in stronger than expected, resulting in a steep sell off in the market. The potential for sticky inflation led to the higher-for-longer scenario becoming priced into markets, with no interest rate cuts expected by the Fed for the year as of the end of February. That view was upended, however, as the banking crisis led a flight-to-quality preference, and a strong rally in March as Muni yields plunged 30–70 bps over the month. The quarter ended with the market pricing in two Fed interest rate cuts by the end of 2023.
The result of the roller coaster ride that was Q1 2023 was a total return in Municipal and Municipal High Yield sectors of 2.78%1 and 2.73%2, respectively; slightly underperforming its taxable counterparts with US Aggregate returning 2.96%3, US Treasury returning 3.01%4 and US Corporate High Yield returning 3.57%.5 The underperformance left ratios slightly less rich, with 5-, 10-, and 30-year ratios at 61%, 65%, and 89.5%, respectively.
Supply, or lack thereof, provided a tailwind for municipal bond performance as issuance during the first quarter was down approximately 29% relative to last year. The volatility in interest rate markets, as well as lack of transparency of the Fed path, has made issuers hesitant to come to market, leading many Wall Street banks to downsize their issuance forecasts for the year. Despite a disappointing first quarter in issuance, we expect it to pick up as the trajectory of the Fed hiking cycle becomes clearer with the majority to come in the second half of 2023.
From a demand perspective, fund flows were negative for the quarter with $1.7 billion flowing out of the municipal bond market in aggregate.
A more stable credit base for Muni investors
As we stated in our 2023 outlook, we believe municipal bond fundamentals are strong. The space has continued to see upgrades outpace downgrades over the first two months of the year, with S&P reporting an upgrade to downgrade ratio of 2.7 to 1.0. The combination of Federal stimulus as well as the strength of the employment market have bolstered municipal balance sheets and kept tax collections elevated by way of increased income, sales, and property tax receipts. Given these dynamics we believe municipals provide a stable credit base to weather a potential economic slowdown or recession. In particular, we are constructive on sectors that tend to be counter cyclical in recessionary environments including education and healthcare.
The banking crisis, as well as the recent softening in economic data, has led us to gradually increase our duration positioning over the past weeks in order to capitalize on the recent strong market rally. While we would look to continue to extend duration incrementally, we are still cautious to extending ourselves to being overweight in duration as the strength of the employment market and sticky services’ inflation figures provide a case for the Fed to keep rates elevated for a longer period.
In the second quarter, we continue to take a cautious approach to municipal market positioning. As we potentially head into an economic slowdown, the municipal bond market should benefit from its higher quality and defensive characteristics. This flight to quality could lead to inflows in the asset class. While we look for value in lower quality names and perhaps longer duration structures, we would not recommend a one-size-fits-all strategy for municipal bonds as inflation and interest rate risks remain. Economically sensitive sectors, such as sales tax-backed or commercial lease backed-revenue bonds may also underperform in a recessionary period. For those investors looking to maximize yield, however, a bevy of opportunities exist in the municipal market given current macro backdrop when paired with an active investment approach.
1 Bloomberg U.S. Municipal Index, as of March 2023.
2 Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD
3 Bloomberg U.S. Aggregate Index, as of March 2023.
4 Bloomberg U.S. Treasury Index, as of March 2023.
4 Bloomberg U.S. Corporate High Yield Bond Index, as of March 23.
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.