Perspective published on November 15, 2022
Follow the Wind
- The municipal market currently offers an attractive entry point.
- Expected risks have repriced spreads and market supply technicals are improving.
- In-depth analysis and security selection will prove increasingly valuable.
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.
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.
 Assumes 40.8 percent marginal tax rate. AA muni rate as of 10/28/22 was 3.63 percent.
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