NEWS AND INSIGHTS | INSIGHTS

Municipal Bonds: Yield and Volatility ‘Silver Lining’

July 25, 2022
JAMES ISELIN, HEAD OF MUNICIPAL FIXED INCOME

Recent price weakness has opened up avenues for return potential.

The first half of 2022 was particularly painful for fixed income investors, as bonds failed to provide the diversification benefits many had come to expect in periods of equity market turbulence. Municipal bonds were not immune, as the Bloomberg Full Market Municipal Index dropped about 9% through June. (Shorter maturities tended to fall less—about 5.5% for five-year bonds.) However, although the setbacks were meaningful, we see a silver lining in recent events: higher yields and renewed opportunity to potentially add value through active management.

Last year, when central banks were cocooning financial markets from the pandemic, yields were close to zero and it was very difficult to gain advantages from fundamental insights—as even questionable issuers saw their valuations lifted by easy monetary policy. However, given the sizable upward move in rates this year, combined with cheapening valuations, absolute yields across fixed income are much higher than in December. We believe this is providing opportunity in various sectors, including investment grade corporates, high yield—and municipal bonds.

As of midyear, the average yield on AAA 10-year municipal bonds was more than double the level seen at the start of the year. These yields represent about 90% of those available from corresponding Treasuries, compared to about 70% on January 1—meaning that the federal tax exemption on municipal income is now close to free.

Beyond yield, however, we believe conditions are ripe for active management in municipals. Although credit quality remains strong, dealers of new financings are eager to move product and are willing to make concessions to find buyers. In secondary markets, investor outflows are creating many “forced sellers” who otherwise might rather hold onto bonds until recovery or maturation.

In our view, active managers have the potential to capitalize on these dynamics, as well as shifting market views on the economy and Federal Reserve policy. Rather than a static market, we are seeing a rapidly evolving one, rife with uncertainty and therefore opportunities to potentially add value through fundamentally driven research and trading—as well as, where possible (in the case of separate accounts), “swapping” securities to capture losses for tax purposes.

From a risk perspective, municipal credit quality tends to be like a slow-moving ship—as tax-base deterioration for local credits usually lags relative to declines in the broader economy. State governments can be more cyclically sensitive, and we will be watching closely to see how their fortunes evolve.

In the meantime, we remain somewhat cautious on interest rates, but overall are finding ample opportunities as we sort through a newly dynamic marketplace.

Upward Move in Yields Across Maturities

AAA Municipal Bonds

Municipal 

Source: Bloomberg. As of June 30, 2022. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

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