Green Shoots Emerging for Municipal Bonds

There’s ample carnage to go around in the bond market this year as confirmed by a double-digit year-to-date loss by the Bloomberg US Aggregate Bond Index.

Municipal bonds aren’t immune from that downside. For example, the widely followed ICE AMT-Free US National Municipal Index is lower by 7% this year. Obviously, that’s less bad than the aggregate index, but it’s a far steeper decline than muni investors – many of whom are looking to dial back risk – bargained for at the start of 2022. Clearly, munis are rate-sensitive.

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.

Hopefully, History Repeats

One of the most timeless and still relevant financial market maxims is that history doesn’t always repeat, but it often rhymes. For advisors and muni-exposed clients, hopefully that will be the case this time around because this corner of the bond market has a history of performing well following periods of rising yields.

“Rising rates resulting in widening yield spreads have been short lived. A more dramatic spread widening has been caused by either headline shocks or black swan events, such as the 2008 financial crisis and more recently the onset of the pandemic in 2020,” according to VanEck research.

Yes, prior rate hike cycles are just that: Prior. And no, history doesn’t always repeat. All that said, munis’ performance, including junk-rated debt, from start to finish in the previous rate hiking regimes is something to behold.

“This is the third rate cycle to occur over the past two decades. The last two were June 2004 through June 2006 and October 2015 through February 2019. If you bought municipals at the beginning and held until the cycle’s end during the first cycle, based on Bloomberg broad indices, investment grade returned 9.91% and high yield returned 24.12%; during the second cycle, they returned 9.65% and 20.45%, respectively on a cumulative basis,” adds VanEck.

Signs of Recovery

There is value in collective wisdom. To that end, municipal bond exchange traded funds hauled in $4.2 billion in fresh capital in the second quarter, good for one of the highest totals among all fixed income ETF segments.

When getting into billions in terms of ETF flows, regardless of asset class, that usually means professional money, including adviors working on behalf of clients, is being put to work. So it be prophetic that money managers are again warming to munis. At the very least, history says it’s an appropriate time to give the asset class a fresh look.

“We most certainly find ourselves in a pronounced hiking regime, as the Federal Reserve (Fed) attempts to bring down inflation,” concludes VanEck. “Yields are now at levels not seen since October of 2018. Despite the prospect of additional Fed action to push short rates higher, re-entry into municipal assets rewards investors with the benefit of exempt income and may yet generate modestly positive returns through year-end.”

Related: Active Management Could Be Difference Maker for Fixed Income Investors