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Municipals

WhereVolatilityMeetstheOpportunityinMunicipalBonds

By Jason Appleson, CFA, FRM — Nov 17, 2022

7 mins

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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%.

Figure 1

Muni Bond Yield Rose Sharply on Record Outflows

Source:

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.

Figure 2

Issuance Slows as Rates Tick Higher

Source:

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.

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  • By Jason Appleson, CFA, FRMHead of Municipal Bonds, PGIM Fixed Income
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The comments, opinions, and estimates contained herein are based on and/or derived from publicly available information from sources that PGIM Fixed Income believes to be reliable. We do not guarantee the accuracy of such sources or information.  This outlook, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and our views are subject to change. Past performance is not a guarantee or a reliable indicator of future results.

Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of November 17, 2022.

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PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iii) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”); (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) PGIM Netherlands B.V., located in Amsterdam (“PGIM Netherlands”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom, or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.

In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 - Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.

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