The Transition to Net Zero: A Challenge for Central Banks
Highlighting the potential consequences for inflation in the euro area over the transition period to net zero, and implications for monetary policy.
Municipal bond investors have endured an unprecedented drawdown so far in 2022, with the index declining by a record 7.6% through the first five months of the year amid the Fed’s hawkishness and the concurrent increase in Treasury yields. However, a number of technical factors amplified the underperformance, and current valuations ignore the underlying credit strength of most municipal issuers. Yet, tides are temporary. The confluence of modest new issue supply, rising reinvestment activity, increased demand from crossover buyers, and positive credit trends suggest the market is poised to turn quickly in the event U.S. Treasury yields continue to stabilize.
Municipal bonds have posted outsized negative returns so far in 2022, underperforming U.S. Treasuries across the curve and leaving Muni/Treasury ratios at their cheapest levels since late 2020. While some level of underperformance had been expected, declines were amplified by a “perfect storm” of technical factors. These include:
Consider the above in the context of the strengthening credit fundamentals. Many municipal issuers exited the COVID crisis stronger than before, with an estimated $1.2 trillion flowing into municipal entities from government stimulus programs. Further, another $500 billion infrastructure bill that was passed in late 2021 ensures years of additional funding for many sector participants. At the same time, tax collections have risen sharply amid increased consumer spending, prolonged wealth effects, and rising house prices. Issuers have used higher tax revenues to pay down debt, fund pension liabilities, and/or make deposits into rainy-day funds.
While inflation presents a clear and present risk in the form of higher expenses and capital costs, municipal issuers might also derive some benefits. Rising consumer goods prices, employee wages, and home prices translates to higher sales taxes, income taxes, and property taxes, respectively. Additionally, many revenue sectors associated with higher inflation, such as airports, toll roads, tobacco bonds, and utilities, contain pass-through mechanisms that deliver benefits from rising costs.
These positive credit trends have already resulted in a number of upgrades. On a combined basis, Moody’s Investors Services and Standard & Poor’s have upgraded 7.5 municipal issuers for every one that they downgraded in the first quarter of 2022.
Despite improving fundamentals, many credits, such as Illinois for example, continue to experience sharp selloffs. Illinois has the lowest credit rating of all the states, rated just above investment grade heading into the pandemic. Although the state experienced a series of setbacks at the outset of COVID, Illinois realized healthy tax collections in the months that followed and received a mountain of federal aid. This resulted in a healthy balance sheet cushion, with recent budgets calling for the repayment of debt, additional pension liability payments, and a deposit into a rainy-day fund for the first time in recent history.
Amid this increasingly positive credit news, the ratings agencies raised Illinois’ ratings by two notches to Baa1/BBB+. Nevertheless, spreads on Illinois’ long bonds have widened materially, caught up by the technical headwinds facing the rest of the municipal bond market (Figure 2).
And Illinois is not alone. The technical factors pushed yields on the benchmark muni index three times higher than they were to start the year, leading to a stark disconnect between valuations and credit fundamentals (Figure 3).
While it is difficult to pinpoint when the outflows may turn, other technical factors are easier to predict. Tax season is now over, and reinvestments should pick up in June, July, and August, causing net supply to shrink to about negative $30 billion. And, with municipal bond market valuations at or near their cheapest levels versus corporates in over ten years, crossover buyers may emerge as a significant source of demand. As the technical tide ebbs, the improvement and strength of muni credit fundamentals should come to the fore and support a quick recovery amid further stabilization in rates, even as a potential monetary policy-induced recession looms on the horizon.
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