Municipal bonds are now offering a more attractive entry point. In the first quarter of this year, our article Tailwinds to Headwinds: Navigating a Shifting Landscape in Municipal Bonds discussed a likely shift of market tailwinds into headwinds and the impact they could have on municipal bond spreads over the course of 2022. We examined dynamics including changing monetary and fiscal policy, fading effects of financial stimulus, peaking fundamentals, and increasing inflation concerns.

Our hypothesis was that the municipal market was at an end to what we had internally dubbed the Great Compression and the new environment would require investors to decouple from a tailwind mentality and implore more research to properly assess risk and widening spreads. Since our publication, yields have increased significantly, spreads have widened, and tax-equivalent yields have become more attractive at higher all-in rates. We are now in an opportunistic environment for active managers with comprehensive research capabilities.

Municipal spreads have decompressed

Year-to-date through October 31, 10-year AAA muni yields increased 236 basis points (bps), one of the most dramatic moves in the exempt market’s history. As shown in Figure 1 all issuers are now facing higher borrowing costs compared to 2021 given the rapid rise in municipal yields. Lower quality issuers have seen rates rise even higher.

As seen in Figure 2, lower-rated issuers have experienced widening spreads relative to AAA bonds. Reasons behind the widening spreads included topics outlined in our March piece combined with additional developments in global markets. The spread on AA credit compared to AAA credits is now 24bps, compared to just 12bps at the start of the year. It is clear that we have moved to an environment where credit risk requires more payment than it did in 2021, even for strong issuers.

Further, the selloff in rates was not uniform, and we have seen differentiated performance among ratings categories and sectors. For example, the hospital sector experienced significant widening, with A-rated health care system spreads increasing by 47bps during 2022, versus 22bps for single-A GO bond issuers. Some widening in this sector is justified given the negative impact the pandemic has had on hospital operations, however, at these wider levels, we believe some higher-quality systems are now more appropriately compensating investors for the known headwinds unique to the sector (See Figure 3). We now see the rising probability of a transition from spread decompression to a more rangebound market, with even potential for modest spread compression in the near term given supply technicals.

Municipal bonds are at higher yields, which translate to attractive taxable equivalent yields. As of Oct 31, 2022, the 10-year AA muni rate provides a taxable equivalent yield of 6.13 percent, or 208bps above the comparable Treasury¹. Obtaining this yield with a taxable fixed income product that offers a similar risk profile is challenging to accomplish. The attractiveness of these higher yields combined with lower supply dynamics should provide some cap to rates in the current economic environment.

Measuring risk with opportunity

Municipal bond investors have faced a rapidly changing economic environment so far this year. We expect market conditions to continue to evolve but believe opportunities currently exist for discerning investors.

When our initial piece was published in March 2022, the Federal Reserve (Fed) was just beginning its rate hiking cycle to combat inflation, with a 25bps increase to the federal funds rate. Since then, the frequency and magnitude of rate hikes were greater than initially forecasted. After a 50bps hike in May, the FOMC increased rates by 75bps at four consecutive meetings, with the market pricing in another 50 to 75bps hike in December. As a result, the Treasury rates dramatically shifted upward, with the 10-year Treasury closing October 2022 at 4.04 percent (See Figure 4). In comments following its November meeting, Chairman Jay Powell maintained the Fed’s inflation fight remains priority number one and data dependent. The Chairman stressed that although data may allow for smaller incremental rate increases, the terminal rate will likely remain higher for longer than many market participants had hoped for. Looking ahead, we see a high likelihood of recession as the FOMC continues to increase rates to tame inflation by slowing down the economy.

All else equal, the spread widening of 2022 reflects the market pricing in the increasing probability of a recession. A faster or deeper deterioration and slowdown beyond market expectations could result in continued spread decompression in an environment where federal fiscal policy support is less likely. Rising rates has made debt-backed expansionary policy significantly more costly and the overall appetite for stimulus has decreased significantly given rising inflation.

However, with risk comes opportunities when you can lean into thorough credit analysis to identify the extent of weakening issuer balance sheets. Comprehensive analysis is necessary to identify risks and determine appropriate value, particularly in times of economic uncertainty.

While our research team expects municipal credit conditions to weaken in 2023 in response to tightening monetary conditions, market issuers are going into it well capitalized thanks to a strong base built by federal relief and strong tax receipts. The outlook for slowing economic growth has widened spreads over the course of 2022. Our credit team acknowledges some sectors will be more impacted than others and require more discrimination and deeper analysis. This said, we do not anticipate spreads approaching Financial Crisis levels due to both current financial footing and investor acknowledgement that the municipal market provides very low default risk.

Shifting winds

The Great Compression has ended, at least for now, and investors are now receiving more compensation for credit risk. Spreads have widened among issuers in differing ratings and sectors, and credit selection should prove increasingly valuable in the higher rate environment. This is not a blanket invitation to jump indiscriminately back into the municipal market, however, we believe current spread levels now provide prudent investors who do comprehensive research with an attractive entry point.

(1027)

#313323 (11/15/2022)

[1] Assumes 40.8 percent marginal tax rate. AA muni rate as of 10/28/22 was 3.63 percent. 

DISCLAIMER:
This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.

Any estimates, targets, and projections are based on Breckinridge research, analysis, and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits.

Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. Performance of indices may be more or less volatile than any investment strategy.

Performance results for Breckinridge’s investment strategies include the reinvestment of interest and any other earnings, but do not reflect any brokerage or trading costs a client would have paid. Results may not reflect the impact that any material market or economic factors would have had on the accounts during the time period. Due to differences in client restrictions, objectives, cash flows, and other such factors, individual client account performance may differ substantially from the performance presented.

All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.

Breckinridge believes that the assessment of ESG risks, including those associated with climate change, can improve overall risk analysis. When integrating ESG analysis with traditional financial analysis, Breckinridge’s investment team will consider ESG factors but may conclude that other attributes outweigh the ESG considerations when making investment decisions.

There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency and transparency and for certain companies such data may not be available, complete or accurate.

Breckinridge’s ESG analysis is based on third party data and Breckinridge analysts’ internal analysis. Analysts will review a variety of sources such as corporate sustainability reports, data subscriptions, and research reports to obtain available metrics for internally developed ESG frameworks. Qualitative ESG information is obtained from corporate sustainability reports, engagement discussion with corporate management teams, among others. A high sustainability rating does not mean it will be included in a portfolio, nor does it mean that a bond will provide profits or avoid losses.

Net Zero alignment and classifications are defined by Breckinridge and are subjective in nature. Although our classification methodology is informed by the Net Zero Investment Framework Implementation Guide as outlined by the Institutional Investors Group on Climate Change, it may not align with the methodology or definition used by other companies or advisors. Breckinridge is a member of the Partnership for Carbon Accounting Financials and uses the financed emissions methodology to track, monitor and allocate emissions. These differences should be considered when comparing Net Zero application and strategies.

Targets and goals for Net Zero can change over time and could differ from individual client portfolios. Breckinridge will continue to invest in companies with exposure to fossil fuels; however, we may adjust our exposure to these types of investments based on net zero alignment and classifications over time.

Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.

The effectiveness of any tax management strategy is largely dependent on each client’s entire tax and investment profile, including investments made outside of Breckinridge’s advisory services. As such, there is a risk that the strategy used to reduce the tax liability of the client is not the most effective for every client. Breckinridge is not a tax advisor and does not provide personal tax advice. Investors should consult with their tax professionals regarding tax strategies and associated consequences.

Federal and local tax laws can change at any time. These changes can impact tax consequences for investors, who should consult with a tax professional before making any decisions.

The content may contain information taken from unaffiliated third-party sources. Breckinridge believes the data provided by unaffiliated third parties to be reliable but investors should conduct their own independent verification prior to use. Some economic and market conditions contained herein have been obtained from published sources and/or prepared by third parties, and in certain cases have not been updated through the date hereof. All information contained herein is subject to revision.  Any third-party websites included in the content has been provided for reference only. Please see the Terms & Conditions page for third party licensing disclaimers.