The bond market’s historic selloff in 2022 featured elevated inflationary pressures, a lower growth outlook, higher geopolitical risk, and a succession of outsized Fed rate hikes. Municipal bonds were especially hard hit, logging their worst annual performance on record as investors pulled more than $100 billion from the asset class. The cumulative effect has been a sharp increase in municipal bond yields, with the yield on the benchmark index rising to its highest level in over a decade. While recognizing that volatility may continue over the near term, we believe the high tax-equivalent yields of municipal bonds, coupled with solid credit fundamentals and a more favorable technical backdrop, suggest good long-term value for investors willing to look beyond the next one or two rate hikes from the Federal Reserve.
Aggressive Fed tightening led to a sharp repricing of municipal bonds in 2022, with yields rising across the curve (Figure 1). The selloff has been most pronounced at the front end of the curve, with the yield on two-year AAA municipal bond yields rising over 250 bps since the beginning of the year to approximately 2.79%—a level not seen since the Global Financial Crisis in 2008. Meanwhile, 30-year AAA municipal bond yields have topped 3.6%, or 6% on a tax-equivalent basis for an investor in the highest federal tax bracket. For context, the yield on the Bloomberg U.S. Aggregate Bond Index currently stands at approximately 4.62% and the yield on the Bloomberg U.S. Corporate Investment Grade Index currently stands at 5.41%.
Muni Bond Yield Rose Sharply on Record Outflows
Lipper, MMD, PGIM Fixed Income. As of 11/11/2022.
Historically Low Defaults During Downturns
The primary, negative consequence of the Fed’s aggressive tightening is the increased risk of an economic slowdown, and most economists expect at least a shallow recession in 2023. While U.S. corporate earnings were mixed in the most recent quarter, many companies issued warnings for the coming quarters as the environment is becoming increasingly challenged. Municipal bonds, however, have proven to be resilient in challenging times and strong credit fundamentals should be supportive as economic growth slows.
The historical performance during downturns provides context to that comparison. Indeed, the average five-year municipal default rate between 1970 and 2020 was just 0.08%, which compares to an average five-year corporate default rate of 6.9% over the same period, according to Moody’s Investors Service.1
Additionally, the influx of pandemic-related stimulus money, healthy tax collections, and prudent savings practices have municipalities on a very strong financial footing. State tax collections, though slowing, are still nearly 20% higher than pre-COVID levels.
A Dearth of Supply
Moreover, the shorter-term technical environment paints a bright picture for municipal bonds. While rate volatility has been the underlying cause of outflows, its side-effects have discouraged issuers from coming to the market. Tax-exempt municipal supply is down 18% this year, and negative supply of $15 billion is expected in November and December (Figure 2). When the dearth of supply is paired with healthy amounts of reinvestment in November and December, it creates a supply/demand imbalance that can compensate for some of the cash leaving municipal bond funds. The technical tailwind in the secondary market may become even more brisk given the limited trading days left in 2022 before the holidays ramp up and the market approaches the historically slow issuance months of January and February.
Issuance Slows as Rates Tick Higher
Bloomberg, PGIM Fixed Income. As of 11/11/2022.
A More Certain Path
Although the timing of when interest rates will peak—and its effect on certain asset classes—is uncertain, the Fed’s tight monetary policy is already having an impact on the most sensitive areas of the economy, such as housing and consumer spending. At some point, more of the economy will likely slow, and inflation will moderate enough for the Fed to tighten policy less aggressively. Rate markets are currently pricing in a Fed pause sometime between the first and second quarter of 2023, and our macro-economic team currently anticipates a 50 bp and 25 bp rate hike in December and January, respectively, followed by precautionary rate cuts by the end of the second quarter of 2023.
As the Fed’s path becomes more certain, rate volatility should subside materially, reducing at least some of the technical headwinds municipal bond investors faced over the past year. With valuations increasingly attractive, the technical environment becoming more favorable, and credit fundamentals remaining strong, we believe municipal bonds currently offer good long-term value for investors looking through to the end of the Fed rate hiking cycle.
We currently see value at the front-end of the muni curve, where yields have risen the furthest and fastest. We also favor sectors/individual credits that have sold off the most, despite improvements in the fundamentals. Examples include the airport and tobacco bond sectors and individual credits such as the State of Illinois, Chicago, and Puerto Rico Sales Tax Bonds. Most of the selloff in these examples were technically driven and don’t reflect the improved financial picture that has been buoyed by federal stimulus, a rebound in economic activity, and higher inflation.
1Moody’s Investors Service. “Moody’s publishes annual municipal default study, covering the 51-year period through 2020.” July 9, 2021.