Municipal Bonds Could Be 2023 Bond Stars

Municipal bonds weren’t immune from last year’s bond market tumult, but debt issued by states, cities and the like did outperform the broader bond market.

Last year’s less bad showing has some market observers optimistic about the prospects for munis in 2023, particularly because fundamentals for these bonds, even high-yield fare, remain sound. Additionally, many clients’ needs for income and tax benefits haven’t waned. If anything, those demands are increasing.

“For the first time in a long time, yields are attractive. At the beginning of the year, the yield on the Bloomberg Municipal Bond Index was close to 1%, near the lowest level in the history of the index. That’s no longer the case,” according to Charles Schwab research. “The yield on the index has risen to roughly 3.4%. While this isn’t as high as other fixed income options, municipal bonds are one of the few investment options that are often exempt from federal and potentially state income taxes if the issuer is located in your home state, so after adjusting for this, they are attractive relative to alternatives.”

Yields are just one reason why advisors may want revisit municipal debt this year. Fortunately, there are factors adding to the positive side of the equation.

Favorable Factors for Munis

Adding to the allure of municipal bonds in 2023 is that there are attractive opportunities at both ends of the credit spectrum – investment-grade and high-yield.

“The majority of investment grade issuers are well positioned should the U.S. economy enter a recession in 2023,” notes Goldman Sachs Asset Management (GSAM). “Spreads widened in 2022 as the global economic picture darkened and mutual fund outflows created immense selling pressure. As the dust settles, we see a larger opportunity set in lower-rated credits.”

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.

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.

“Strong economic and job growth bolstered muni credit in 2022. We expect munis to continue to show strength into 2023, however revenue velocity is expected to moderate along with the economy. In the high yield space, we do see sector specific pressures continuing into 2023, which can also provide investment opportunities,” adds David Alter, head of AM research at GSAM.

Keep Calm, Carry On

It’s often noted that a higher a bond’s yield is when an investor purchases it, the better the odds are that the investor will attain a positive outcome. That’s advice worth remembering in 2023 because muni yields touched unusually high levels last year.

“We believe 2023 will be a year to maintain a neutral position and let the elevated yields purchased in 2022 work for investors in the form of carry. Investors may experience mid-single digit returns in 2023 as we begin the year with tax-free AAA muni yields between 2.50% and 3.50% and see the potential for a stable or potentially lower interest rate environment ahead,” concludes GSAM.

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