- During the 2000s, municipal bonds provided investors with stable income free of federal income tax  diversification, and capital preservation.
- Over the last decade, low yield environment has motivated investors to seek higher yields outside of traditional investment grade portfolios
- Given a recent and rapid rise in yields, we also consider the environment for municipal bond investing as we move forward from 2022.
Investors have long relied on municipal bond allocations to provide three essential roles within their asset allocation: income, diversification, and capital preservation. While past performance is no guarantee of future performance, we take a look at periods during the last 22 years when municipal bonds met their asset allocation expectations to consider their prospects in the period ahead.
Municipal Bonds as Pillars of Portfolio Construction
A high quality, intermediate-duration municipal portfolio has delivered counterbalancing attributes of income, diversification, and capital preservation during volatile market environments in the years since 2000.
The Great Financial Crisis of 2008 (GFC) illustrated that importance with the S&P 500 down 38.5 percent for the 12 months ended December 31, 2008. A high quality, intermediate-duration municipal bond allocation, as represented by the Bloomberg Managed Money Short Intermediate Index2 (the Index), was up 5.63 percent during the same period.
The subsequent zero interest rate policy of the Federal Reserve (Fed) for the eight years after the GFC was a watershed moment for fixed income markets and municipal bonds were no exception. This period at the zero bound, the slow and modest hiking cycle from 2015 to 2018, and the return to the zero bound as a result of COVID-19 was a recipe for positive total return for bonds and set the environment for decreasing yields across the fixed income universe.
Fast forwarding to 2022, we started the year near record lows. The Index, a proxy for intermediate high quality municipal bonds, had a yield to worst of 0.71 percent on January 1, or just over the 1 percent on a tax-equivalent yield (TEY)3 basis.
The rate reset in 2022 has moved the Index to a yield-to-worst of 3.38 percent as of October 31. This equates to a TEY of 5.71 percent using the top federal tax burden. That move is so large, you’d have to go back four decades to find a rate move to top it.
In the years following the GFC, rate increases or, on the other side of the price/yield relationship, price declines, never seemed to persist. To that end, looking at the 12-month rolling returns of the Index from January 1, 1992, through November 7, 2022, every time returns moved close to zero or slightly negative, the market bounced back significantly over the next 12 months (Figure 1). The rate rise of 2022 certainly appears to be different this time.
Pre-March 2020, investment grade, intermediate municipal bonds, as measured by the Index, exhibited long-term negative correlations with risk assets such as the S&P 500. While Treasuries were still considered the safe haven bellwether, high quality municipal bonds also provided an ideal counterbalance to risk assets in difficult years such as 2008.
Post-March 2020, historical correlations for many bond proxies began to shift slightly closer to the S&P 500, calling into question the diversification benefit of some bond markets. This has continued in 2022 with the S&P down 18.22 percent year-to-date through October 31 and the Index down 8.76 percent.
That said, bond market correlations with risk assets appear to be reverting to historical norms. Relative to the S&P 500, Treasuries retain a low negative correlation. High quality intermediate municipal bond correlations, per the Index, are not back to negative territory, but they do show a lower positive correlation. In contrast, low quality indices, such as the Bloomberg U.S. Corporate High Yield Index, exhibit much higher correlations with the S&P 500, making these bonds less compelling from a diversification standpoint.
However, the perception of safety with municipal bonds was never predicated on market price correlations alone, but rather in conjunction with a long history of municipal issuers providing predictable cash flows through coupon payments and maintaining a reliable history of principal payment due on maturity of a bond. The ability to earn a return independent of market fluctuations, via coupon and principal cash flows, is an essential element of what makes owning a bond more predictable than other securities that largely or completely rely on market prices for return.
Municipal bonds have defaulted very infrequently on an absolute and a relative basis. The 10-year cumulative default rate was 0.1 percent for the investment grade municipal universe, 2.2 percent for investment grade corporate bonds, 7.1 percent for below investment grade municipal bonds, and 29.7 percent for below investment grade corporate bonds.7
Municipal Market Outlook
Looking back on historical data and statistics is important, but now let’s look forward to a brief outlook on the municipal market. As a consequence of higher interest rates, new issuance supply has been lower than most expected this year, and we will likely finish with lower year-over-year issuance for the last two months of the year. Lack of supply could be a tailwind for the market heading into next year, particularly if mutual fund flows lessen their historical negative cycle ($120 billion in outflows year-to-date, as of November 4, 2022, according to the Investment Company Institute).
From a credit perspective, most investment grade municipal issuers exhibit strong liquidity, manageable debt levels and have experienced more monthly credit rating upgrades than downgrades for two years straight, according to Moody’s and S&P Global Ratings.
That said, capital market asset price declines and slower growth are starting to impact some credits. Higher interest rates may also impact capital spending even further and lower quality issuers may find it more difficult to refinance or term-out maturing debt.
In terms of relative value, investment grade municipal credit spreads have widened somewhat from the beginning of the year (e.g. the spread for 10-year general obligation rated A widened from 22 basis points (bps) to 44bps from January 1, 2022 through October 31, 2022).
Year-to-date, there has been differentiated performance across sectors and categories. With comprehensive research, municipal investors may be able to find some attractive values but there hasn’t been a dramatic spread widening that would indicate aggressively moving down the credit scale.
Fortunately, municipal investors don’t need to go too far out the risk spectrum to find yields approaching levels not seen since the GFC, as shown below.
Figure 3 represents the month-end spreads between the TEYs of 2-, 5-, and 10-year AAA GO municipal bonds, and the yields of 2-, 5-, and 10-year U.S. Treasuries, between September 30, 2002, and September 30, 2022. Prevailing top marginal federal tax rates and net investment income tax rates used to derive month-end TEYs are as follows: 2002: 38.6 percent; 2003 through 2012: 35 percent; 2013 through 2017: 43.6 percent; and 2018 through 2022: 40.8 percent.
As of September 30, 2022, when adjusted for the prevailing top marginal tax rate of 37 percent and the 3.8 percent net investment income tax:
- 2-Year AAA GO municipals are outyielding 2-Year U.S. Treasuries by over 100 basis points.
- 5-Year AAA GO municipals are outyielding 5-Year U.S. Treasuries by over 125 basis points.
- 10-Year AAA GO municipals are outyielding 10-Year U.S. Treasuries by over 175 basis points.
Since September 2002, when adjusting for the prevailing top marginal tax rate the spread between tax-adjusted municipals and Treasuries have rarely breached these thresholds. It has occurred:
- In 8 percent of month-ends for spread for the 2-Year maturity.
- In 9 percent of month-ends for spread for the 5-Year maturity.
- In 12 percent of month-ends for spread for the 10-Year maturity.
Excluding the GFC from July 2007 through June 2009, the figures drop to 2 percent, 3 percent, and 9 percent for the 2-Year, 5-Year and 10-Year maturities, respectively.
As we consider the environment for municipal bond investing beyond 2022, we believe municipal bonds are well-positioned to fulfill their historical roles providing portfolios with stable income, diversification, and capital preservation.
 Municipal bonds are free from federal taxes and are often free from state taxes. If the bond purchased is from a state other than the purchaser's state of residence, the home state may levy a tax on the bond's interest income.
 The Bloomberg Municipal Managed Money Short Intermediate Index measures the performance of the publicly traded municipal bonds that cover the USD-denominated short/intermediate term tax-exempt bond market, including state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds. It is rules-based and market-value weighted.
 The tax-equivalent yield is the return that a taxable bond would need to earn in order to equal the yield on a comparable tax-exempt municipal bond. The calculation is a tool that investors can use to compare the returns between a tax-free investment and a taxable alternative.
 The S&P 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.
 The Bloomberg U.S. Treasury Index measures the performance of public obligations of the U.S. Treasury, including securities that roll up to the U.S. Aggregate, U.S. Universal, and Global Aggregate Indices.
 The Bloomberg U.S. Corporate High Yield Bond Index is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market. The index is composed of U.S. dollar-denominated corporate debt in Industrial, Utility, and Finance sectors with a minimum $150 million par amount outstanding and a maturity greater than 1 year. The index includes reinvestment of income.
 Moody’s Investors Service annual default rate study.
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