Perspective published on March 25, 2022
Tailwinds to headwinds: Navigating a shifting landscape in municipal bonds
- Monetary and fiscal policy, financial stimulus, solid fundamentals, and low inflation drove a Great Compression among spreads between credit risk profiles over the last decade.
- Conditions are shifting, and what were once tailwinds may become headwinds for municipal bond issuers and investors.
- It is prudent for investors to consider how the changing winds of fiscal policy, monetary policy, and inflation will influence different risk profiles over the long term.
Mount Washington is the tallest mountain in the northeast United States and is notorious for its erratic weather. For 75 years, it was considered the windiest place on earth and recorded gusts of up to 231 miles per hour, which is equivalent to a Category 5 hurricane. On a typical day, depending on its direction, the wind can make your ascent either easier or substantially more difficult. Similarly, there are economic headwinds and tailwinds in the municipal market that can have the same impact on spreads. Over the past decade, strong tailwinds of easy monetary policy, abundant fiscal stimulus, and low inflation drove the market’s required spread for credit risk tighter. In 2022, even after a meaningful sell-off in munis, credit spreads among risk profiles remain fairly compressed, even as tailwinds shift into headwinds.
For the better part of the last decade, the market acknowledged that credit risks lessened due to strong municipal balance sheets and consistent inflows. Amplifying external tailwinds, a lower overall yield environment perpetuated a hunt for yield that compressed credit risk spreads even further.
We’ve internally dubbed this post-Great Financial Crisis (GFC) environment the “Great Compression.” However, many of those tailwinds are changing direction. Yet spread differentials remain relatively tight and merit longer-term consideration. In times like this, a high quality municipal bond portfolio built on independent forward-looking research can provide an additional measure of risk mitigation.
Intuitively, the spread between credit ratings is largely based on fundamentals, and admittedly fundamentals remain strong. However, while municipal balance sheets are resilient in the near term, it is prudent for investors to consider how the changing winds of fiscal policy, monetary policy, and inflation will influence different risk profiles over the long term.
As federal support moves out, predicting financial stress gets more complicated
As tailwinds become headwinds, credit spreads should more clearly distinguish between credits that are able to comfortably meet their future needs with internally generated resources absent fiscal policy support.
Federal action taken during the depths of the pandemic was unprecedented in regard to both breadth and magnitude. Local governments’ self-sufficiency and long-term financial planning should be analyzed absent fiscal support.
The shift to less direct federal aid is happening at the same time the Federal Reserve (Fed) begins to transition into a tightening monetary policy cycle, with higher short-term rates and a decreasing balance sheet.
Inflation adds pressure to municipal planning
Of the shifting winds, inflation remains the biggest unknown with respect to the longevity of economic deterioration. In January, the Core Personal Consumption Expenditures Index rose 5.2 percent year-over-year (Y/Y), while the Core Consumer Price Index (CPI) rose 6.0 percent Y/Y. Inflation expectations are now the highest in decades. In a period of elevated inflation, municipal issuers would expect to see weakening of credit quality under multiple fronts including, but not limited to:
- Higher costs of necessary capital projects. Municipalities may choose to increase the amount of debt financing or draw down on cash on hand to absorb cost overages. Both options can ultimately begin to reduce credit quality over time.
- Wage pressures impacting day-to-day operations and resulting in higher pension liabilities due to increasing cost-of-living adjustments, where applicable.
- Revenue and expenditure mismatches among issuers subject to property tax caps. Property tax caps have the potential to limit a municipality’s revenue-raising ability during a period of time when expenditures face no such limitations. This results in the need for additional revenues, reduced services, or reduction of reserves.
- Higher financing costs can delay sustainable long-term infrastructure projects in favor of short-term budget solutions.
While all issuers would be impacted, not all are equally equipped to navigate the changing landscape. Individual security analysis is required.
While it is important to acknowledge the inflation risks facing issuers, we also acknowledge the ongoing state of municipal finances. Thanks to a record influx of federal aid, many municipalities are in better shape than they were prior to the pandemic. However, this aid was not a long-term structural change and according to The National League of Cities almost 50 percent of all funding has been committed and budgeted.
The ability for the Great Compression to continue with these newfound headwinds would be an uphill battle, and the likelihood of a more profound decoupling among risk profiles is increasing.
Look back to frame future forecasts
It is useful to examine historical data to consider how spreads changed post-GFC and where they may go post-pandemic.
The GFC ended in 2009 and municipal investors at that time required far more compensation for risk as many investors began to take sharper, differentiated views on underlying credit fundamentals rather than relying on insurance protection.
In 2010, as many markets focused on underlying credit fundamentals and continued to recover from the GFC, 10-year AAA municipal bonds traded in a wide range of 2.17 percent and 3.27 percent.1
While this is a higher range than current yields and may feel out of reach, the market is now just 8 basis points (bps) below the low end of this range, as of March 23, 2022. We are perhaps closer to post-GFC levels than the market appreciates. Nevertheless, despite the move in overall yields, credit spreads between risk profiles have not meaningfully adjusted for credit differentiation.
In 2010, the difference between 10-year AA and BBB municipals averaged nearly 170bps of additional spread. Coming into 2022, the spread was near the post-GFC tights of 45bps. While dramatic, we acknowledge the BBB market is a small percentage of the overall municipal market and highly concentrated. That said, in 2010, the difference between 10-year AA and A municipals averaged nearly 62 basis points of additional spread (see Exhibit 1). As 2021 came to a close, that spread was near post-GFC tights of 10bps.
Over the first two months of 2022, the market experienced significant uncertainty that sparked an emerging spread decompression. Even prior to Russia’s invasion of Ukraine in late February, the markets were reacting to a more hawkish Fed, dramatically increased inflation expectations, and fiscal policy taking a back seat to geopolitical unrest.
Against this backdrop yields quickly moved higher as measured by AAA-rated municipal securities, spiking 105bps. The change in spread between AA and BBB-rated GO municipal bonds during this selloff was more subdued. Year-to-date through March 23, 2022, spreads increased by only 10bps, now currently at 55bps. The spread between A-rated and BBB-rated GO munis has increased only 2bps. And, looking at more diversified rating categories, changes in the A to AA and AA to AAA spreads have been minimal, widening by 8bps and 9bps respectively.
The persistent tailwinds that contributed to the Great Compression eroded the premium investors required for risk. While periods of strong external support and strong balance sheets can be an advantageous environment to reasonably stretch for yield, navigating the reversal thereof is aided by independent fundamental credit research. Intentional decoupling from a tailwind mentality to traverse through the municipal market’s developing headwinds is paramount to the success of today’s municipal bond managers.
 All yield and spread data in this article is per Refinitiv TM3 as of 3/23/22.
Rev# 288621 (3/23/2022)
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.