Among the themes that are abundantly clear in 2022 are the savage repudiation of bonds due to five interest rate increases by the Federal Reserve and active managers, across a variety of asset classes, lagging their benchmarks.
Broadly speaking, those factors apply to municipal bonds, but the ICE AMT-Free US National Municipal Index is outpacing the Bloomberg US Aggregate Bond Index year-to-date and there are signs of optimism for active managers in the municipal bond space.
On the bright side, there’s emerging evidence that while munis are off to a rough start this year, a rebound could materialize as 2022 moves forward. After all, the lower a bond’s starting price is when an investor gets involved, the great upside potential there is.
For example, muni bonds are cheaper today than they were at the start of 2022 while some market observers believe the bond market is pricing in retreating inflation in 2023. Fortunately, there are encouraging signs in muni land, indicating advisors might want to revisit the asset class with clients.
Good Vibes for Munis
One of the compelling reasons for advisors to potentially consider the pairing of municipal bonds with active management is that fundamentals in this fixed income segment are strudy.
“The fundamentals of the muni market are very strong. Strong economic growth over the past couple of years has produced solid revenue growth,” David Blaire, portfolio manager for Nuveen’s municipal fixed income team, in a question-and-answer with State Street Global Advisors (SSGA). “While inflation is undesirable, inflation has translated into even higher nominal growth in tax revenues. Many states and local municipalities have successfully managed expenditure growth and have increased their rainy day funds and reserves.”
As advisors know, a key element bonds that are not Treasuries is credit quality. Indeed, there are high-yield municipal bonds, but they are generally less risky than corporate equivalents and compensate clients for the risk. That’s something to consider at a time when municipal bond downgrades are somewhat rare.
“When you look at credit rating upgrades versus downgrades, upgrades far exceed downgrades over the past year, and we expect that will remain the case in the coming months, even though the economy is slowing,” adds Nuveen’s Blaire. “We believe municipal issuers are well positioned to manage through a much slower economy — and even a mild recession.”
There’s no sugar-coating the struggles of active management this year and that sentiment applies to both exchange traded funds and mutual funds. However, municipal bonds are a segment where active management can potentially benefit clients.
“Active managers can add value in several ways. The first would be staying ahead of the credit cycle and anticipating difficulties that some credits may experience, resulting in downgrades and a cheapening of their bonds. We believe that credit research is essential as part of the municipal investment process,” notes Blaire.
Active muni managers can more nimbly credit and rate risk while sourcing income opportunities that can prove superior relative to index-based strategies. Advisors don’t have to go “all in” on munis and active management, but it’s a pairing worth considering as 2022 draws to a close.