It’s been a year in which inflation and interest rates climbed to highs not seen in recent memory. One of global geopolitical tensions, nowhere more so than in Ukraine, where Russian forces have been wreaking destruction since the early spring. And a time of general financial market volatility. It’s hard to believe that this long, hard year is winding down.
As an asset class, municipal bonds haven’t been immune to the market turmoil of 2022. Returns for the year have been negative and the asset class is in outflows. However, we maintain our confidence in municipal (muni) bond fundamentals, our optimism about the future and our stance that investors may benefit from municipal bond exposure, especially if they focus on shorter-dated paper.
Fourth-quarter choppiness to give way to smoother sailing?
We suspect that the first half of the fourth quarter of this year will look much like the third quarter — outflows will continue and interest-rate volatility in the Treasury market will filter into the muni market.
We’re more sanguine about the second half of the fourth quarter, when we expect market volatility to smooth somewhat as Fed policy moves become less intense. It’s possible that in early 2023, muni markets could even experience a rally and investors rebalance their portfolios for the new calendar year.
Muni fundamentals remain strong especially compared to their corporate counterparts. Year over year, personal income collections are up 10% and sales collections are up 9%. What’s more, at the time of writing, total median tax collections are up 24% compared to August 2020.1 These increases speak to the strength of fundamentals in the muni bond space that could bode well for the asset class.
We maintain that if the economy should tip into recession, there’s still reason for optimism in munis compared to corporates because their sources of revenue are tend to be more economically resilient.
Given these strong fundamentals and muni bond performance thus far this year, combined with just how high interest rates have risen, investors may want to start positioning themselves for a potential rally in the late fourth quarter. In this context, it could be argued that munis are attractively valued at present. But we would be remiss not to mention our caution on interest-rate risk and extending duration.
Tactical opportunities in muni bonds
We see two key tactical opportunities in muni bonds for investors today.
- Short-duaration munis as a cash alternative- a year of surging inflation and market volatility has made many would-be investors wary of traditional investments, particularly in equities. As a result, there’s a lot of cash on the sidelines. Short or ultra-short municipal bonds could serve as an opportune place for investors to park that cash while they wait out the equity market storm and potentially capitalize on all of the things, like tightening Fed policy, causing the storm.
- Tax-loss harvesting with municipal bonds- later in the fourth quarter, questions may arise for investors who have sustained losses throughout this turbulent year surrounding how they want to avoid additional losses with taxes. Here, again, short and ultra-short duration municipal credit could be helpful. These fixed-income instruments are among the lowest-volatility options in the credit market, and they’re tax advantaged, to boot. Plus, with shorter duration instruments, investors don’t need to be as concerned about loss of income, given the flatness of the yield curve, which is typically the main reason they may be reluctant to initiate a tax-loss swapping strategy.
1 Bank of America Global Research, October 2022.
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.