A glimpse back at Q2
The municipal market returned-0.10% in tax exempt and -0.43% in taxable over the second quarter, which compares favorably to US Aggregate returning -0.84%, and US Treasuries returning -1.38% during the same period.1,2,3 Corporate high yield, however, slightly outperformed municipal high yield, returning 1.75% vs. 1.65%, respectively.4,5 The volatility in interest rate markets, as well as lack of transparency of the Federal Reserve's path through the remainder of 2023, has made issuers a bit hesitant to come to market, leading many Wall Street bankers to downsize their issuance forecasts for the year. Lack of issuance in investment grade as well as taxable municipals provided a tailwind for outperformance in those markets relative to their corporate counterparts.
In the high yield space, we believe the fundamentals of the economy provided a more favorable back drop for high yield credit overall as recession calls having been pushed further down the calendar, which has proven to be a rather healthy investment environment for high yield paper.
Flows on the uptick
Municipal bond flows have remained negative throughout the year with Lipper flows in municipal bond funds at $-8.7 billion year to date, as of mid-June. We expect flows to improve over the second half of the year as the pace of outflows has started to abate. In our view the combination of a resilient fundamental environment and elevated rates provide a strong relative value case for investment in the municipal market. Historically, flows in the municipal environment generally improve during recessionary environments as the flight-to-quality trade takes place.
A stable credit base remains for muni investors
The fundamental backdrop remains favorable for municipal bonds as strong tax receipts and consistent consumer demand provide for a healthy fundamental dynamic in the municipal sector. The combination of Federal stimulus as well as the strength of the employment market have bolstered municipal balance sheets. Tax collections, in some cases, are lower than they were last year, however, remain sufficient to stabilize balance sheets. Given these dynamics, we believe municipals provide a stable credit base to weather a potential economic slowdown or recession either later this year or early 2024.
Ratios (municipal bond yields-to-Treasuries) will benefit munis
The municipal bonds yield curve remains inverted with one-year bonds yielded 3.01% as of end of the month; two-year, 2.91%; 10-year, 2.54%; and 30-year, 3.57%.5 We believe ratios will richen in municipal bonds relative to Treasuries, meaning that relative yields in municipals will perform better than their Treasury counterpart over the summer timeframe, due to the lack of supply in the municipal market over the summer months., As it stands today, ratios in the 3-, 5-, 10, and 30-year part of the curve stands at 65.18%, 66.31%, 68.08%, and 92.70%, respectively.5 We believe those numbers will drop from here, which portends better yield performance in the space over that timeframe.
Beware the belly of the curve
Within portfolios, it's imperative investors beware the belly of the municipal bond curve, or the 5- to 10-year maturity range. The municipal bond market’s yield curve is inverted in the belly, but positively sloped and steepens a bit in the longer end of the curve providing attractive yield for those who target these maturities – a strategy that can potentially generate alpha and enhance an investor's total return. The municipal yield curve, illustrated in the chart below, is inverted in the 3- to 12-year part of the curve. This inversion is why investors should be wary to invest in that piece of the curve. As the curve normalizes and steepens, that part of the curve is vulnerable to underperformance.
Figure 1. The municipal curve is inverted in the 3–12 year part of the curve
Source: Bloomberg U.S. Municipal Index, as of June 2023.
Moreover, issuers that have come to market in the first half of the year have been primarily focused on issuance in the belly of the curve, which provides cheaper cost of financing for the issuer but may contribute to underperformance as outsized issuance in that portion of the curve may contribute to a supply/demand imbalance. In our view investors stand to benefit in this environment from an active investment approach implementing barbell strategy – two years and in or 12 years and out.
What's to come for municipal bonds?
We remain more bullish about the third quarter than we do about the fourth quarter, due mostly to valuation and supply. The summer months provide a favorable technical backdrop, with net supply estimated to be $-32 billion June through August – meaning the amount of maturity, calls, interest payments vs. expected issuance.6 We believe that more money chasing fewer bonds tends to drive up valuations and provide a favorable backdrop for outperformance for investors who are willing to pay more to become fully invested.
A look ahead at Q3
The sectors that stand to benefit in the third quarter, we believe, are those affected by a resilient US economy. Sectors like continuing care and retirement stand to benefit from an aging population, or the housing sector, which was buoyed by a lack of supply and has held up quite well. We also look at charter schools, or publicly-funded, tuition-free schools, in areas where the schools themselves offer an enhanced academic value to the community, thereby boosting their demand and relative importance to their local community. In addition, the uptick in discretionary income has led to a rise in aviation activity, therefore we are constructive on airports and airlines as well. We are less bullish on project financing where owners cannot pass the uptick in costs onto the consumer as well as commercial-backed lease structures, which has faced headwinds with work from home trends continuing to persist.
1. Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD.
2. Bloomberg U.S. Aggregate Index, as of June 2023.
3. Bloomberg U.S. Treasury Index, as of June 2023.
4. Bloomberg U.S. Corporate High Yield Bond Index, as of June 2023.
5. Bloomberg U.S. Municipal Index, as of June 2023.
6. JPM Research, as of June 2023.
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.