Municipal bond markets posted the third monthly loss in a row to end October, down 0.85%. For the 90-day period ending October 31, 2023, broad municipal markets were down 4.42%, in an eerie repeat of both 2021 and 2022, years in which the market was also down for three straight months from August through October. The recent losses leave municipal markets down 2.22% on a year-to-date basis, with 60 days left in the year, and at real risk of posting the first back-to-back yearly losses in at least the last 40 years. There is no doubt the municipal market has held up better than most. The broad municipal market is down 9.65% for the rolling two-year period ending October 31, 2023, faring much better than U.S. Investment Grade Corporates down 17.34% and the U.S. Treasury market down 14.62%. Nevertheless, it is understandable that many municipal investors are anxious after the latest round of rate volatility, especially in the normally stuffy, slow moving world of municipal bonds. That said, while no one enjoys short-term pain, the recent reset in municipal markets paves the way for long-term gain. Municipals now stand uniquely positioned to offer high levels of income alongside safety, at a time when economic uncertainty reigns supreme.
The argument for municipals starts with yield. After spending most of the last five years under a 2.5% yield-to-worst, the broad municipal market is now through a 4.25% yield, the highest in well over a decade. Current levels offer investors one of the cheapest entry points into municipals since the Great Financial Crisis (GFC). As of the close on November 2, the Bloomberg Municipal Bond Index yield-to-worst was 4.35%. One must go all the way back to late 2008/early 2009 to find comparable municipal yields.
With taxable equivalent yields over 6.50% (4.35 / (1-35% Federal Tax) = 6.69%) for investors in the highest tax brackets the relative value argument for short-term Treasuries and cash equivalents at 5% to 5.50% has now lost quite a bit of steam.
While cash has been king for the last two years, cash returns lag traditional fixed income returns by a significant margin over longer dated timeframes. The additional yield now available in municipals will make it tough for cash to keep pace when rate volatility mitigates even if interest rates remain elevated. It also seems reasonable to assume price volatility could mitigate moving forward as yield provides more cushion. It is important to note that the lack of “carry” or coupon income made the ride up from 0% interest rates especially painful. With little to no income to offset price losses when yields are under 1%, large moves in interest rates from an effective floor of 0% become acute. Current municipal yields offer attractive levels of income, but the additional cash flows also could offer a much larger cushion against future rate volatility.
In addition to the highest yields municipal markets have seen post-GFC, the asset class seems well positioned to offer a defensive approach to investing in fixed income. The increase in yields over the last several years has certainly made bonds exciting again but it is not all strawberry fields. The current macroeconomic backdrop is one of the most challenging environments for fixed income investors in recent memory. Both the credit environment and the interest rate outlook remain very murky. On the credit side of the equation, credit spreads across fixed income markets remain stubbornly tight. This calls into question whether investors are being compensated for the additional risk. While tighter than average spreads could be consistent with a “soft landing” scenario, they don’t seem lock step with a softening in recent economic data and are most certainly not consistent with any scenario where a recession comes into play. There are signs the U.S. consumer is weakening and the lagged impact of restrictive monetary policy, including short-term rates north of 5%, and tightening lending standards have likely yet to take their full toll. From a credit perspective, the municipal market seems to remain on solid footing. There is no doubt we are seeing the post-COVID fiscal tailwinds of Federal aid wane at the state and local level and are likely seeing fiscal tailwinds shift to headwinds with state and local tax receipts likely to fall should the economy weaken. That said, after the August 1 downgrade of U.S. sovereign debt, 12 U.S. states and a host of county and city credits now have a credit rating higher than that of the U.S. government having AAA ratings from at least two of the major ratings agencies. While municipals will never replicate the liquidity of the U.S. Treasury market there are now many areas that stand on equal or better footing from a credit rating standpoint. Over 65% of the municipal market carries a rating of AA- or higher. With over 50% of the U.S. Investment Grade Corporate market rated BBB+ or lower, the unique combination of income and safety available in municipals have the potential to provide an attractive alternative to U.S. Treasuries without the credit quality sacrifice associated with corporate bonds.
From an interest rate perspective, rate volatility could mitigate as the Federal Reserve approaches an endgame. Unfortunately, the most recent selloff in long-term rates presents a conundrum. Unlike the 2022 increase in interest rates — predicated on concern that the Federal Reserve would keep short-term rates elevated for an extended period — the more recent rate volatility was driven by an increase in long-term interest rates controlled by the market not the Fed. Stronger-than-expected growth in the third quarter could be contributing to higher long-term rates, but continued concerns over the Fed’s ability to get inflation to 2%, along with concerns over the state of the U.S. balance sheet, also seem to be playing a role. Long-term rates on the rise juxtaposed against a weakening economic backdrop will make it tough to follow the traditional playbook of extending duration into economic weakness. On the duration front, short-to-intermediate municipals offer the bulk of longer dated yields without the need for excessive duration risk. In recent months bond investors have been reminded in every possible way just how ugly the recent bond rout has been, rivaling even the worst equity market drawdowns in areas such as U.S. Treasuries. For the rolling three-year period ending October 31, 2023, the Bloomberg U.S. Long Treasury Index was down almost 42%! Long municipals fared much better down 13.50%, but those numbers will get investors’ attention. Losses in the most interest rate sensitive areas of fixed income will naturally get all the headlines but consider the performance of shorter duration holdings over the same time frame. The 1–10-year component of the Bloomberg Municipal Index was down 4.20% and the 3–15-year component was down 5.6%. The insulation against rate volatility in short-to-intermediate bonds tends to get overshadowed by the outstripped losses in the longer dated areas of the market. The silver lining for municipal investors, the yield trade-off for shorter duration is modest with the 1–10-year area of the municipal market offering 90% of the yield of the broad market with less than 60% of the duration.
The recent ride in bonds has been rough, but what seems to get lost in the mix is the fact that, alongside the volatility of the last two years, cash flows have increased fivefold with yields at levels not seen since the Great Financial Crisis. Along with many areas of the bond markets, municipals, were also a victim of the 0% rate era. Municipal market yield to worst bottomed at 0.86% in August of 2021 and the ride back to 4%+ has been bumpy but at least as it relates to yields, bonds are back! Coupon income is by far the largest driver of returns in high grade fixed income, with municipals no exception, and this means in turn that time in the market is much more important than timing the market. It is human nature to place a greater emphasis on recent events but the recent price drawdown in municipals might not be the most reliable indicator of their path forward. The longer the investment horizon the smaller the role played by price volatility with yield becoming the most reliable indicator of future returns. Investors are now staring down one of the best buyer’s markets for municipals in recent memory and for long-term investors it is likely a time run to municipals, not away from them.