With higher yields and cheaper ratios not seen since the height of the COVID-19-led sell-off in March 2020, the municipal bond market is currently offering an "exceedingly appealing" fixed-income option for buyers, municipal strategists say.
Tom Kozlik, head of municipal research and analytics at HilltopSecurities, said investors looking for fixed income investments "should begin adding to their municipal positions, or begin to accumulate municipal positions now and throughout the Fed’s interest rate hiking campaign which is likely to continue through this year.”
Part of the reason munis are appealing as of late, he said, is simply because municipal-specific yields have continued to rise to more attractive levels. The 30-year generic triple-A yield started 2022 at 1.50% and now has risen to 3.21%.
With the 10- and 30-year municipal to U.S. Treasury ratios near 100% and above 100%, respectively, the taxable equivalent yields municipals offer investors is compelling.
Valuations look increasingly attractive relative to other fixed income asset classes, even as rising interest rates continue to weigh on the market, said Peter Hayes, head of the municipal bonds group, James Schwartz, head of municipal credit research, and Sean Carney, head of municipal strategy at BlackRock Inc., said in a report.
Analysts also say that recent volatility could lead to outperformance by municipals if past performance can be any indicator of future trends.
Matthew Gastall, executive director of wealth management at Morgan Stanley, said historically, municipals have outperformed post-rate hikes.
He likened the current market to prior volatile periods in 2013, 2016, and 2018 — particularly the Taper Tantrum in 2013 — when municipals outperformed aggressively once interest rate stability ensued.
“During those years, the municipal market underperformed quickly at first, but once the market settled down it not only outperformed but outperformed aggressively,” Gastall said.
“Right now it seems as if the market is slow to respond to what's happening with U.S. Treasuries because as anticipated, we have seen a healthy pre-summer supply,” he said.
“When we compare the current period of volatility to the Taper Tantrum and to 2018 we have noticed when the volatility is spread out, for the most part, the primary market issuance and supply and everything occurring with the banking community stays active and healthy,” Gastall said.
Lower volatility and attractive valuations helped municipals outperform comparable U.S. Treasuries last month, according to the report. While munis had the worst-performing first quarter in nearly 40 years, shorter-duration bonds, which are less sensitive to interest rates, and higher-rated bonds performed best for the month of April, according to BlackRock.
Supply and demand dynamics weighed on the market in April but should improve in the coming months.
“Seasonal trends are set to turn more historically favorable and supply-and-demand technicals should improve as outflows moderate from tax-time weakness and issuance turns net negative through the summer,” Hayes, Schwartz and Carney said.
In addition, attractive valuations have "already spurred increased interest from crossover investors, which could help to stem the negative feedback loop in which the market has been stuck for most of 2022,” they added.
The broader interest rate moves have also prompted mutual fund outflows Gastall described as a gradual reaction in terms of the “laggard textbook response” from the retail crowd in a market two-thirds controlled by household investors.
As a result, the current short-term market appears as if it is underperforming, but that scenario could change in the next few weeks, according to Gastall.
Couple that with the laggard mutual fund outflows during the rising-rate period and Gastall believes investors could see an opportunity for dollar-cost averaging into higher-quality paper in the near future.
“Outflows accelerated to levels not seen since the height of the pandemic, exacerbated by seasonal weakness surrounding Tax Day,” Hayes, Schwartz and Carney said.
Bids-wanted activity has increased to about $1.7 billion per day as investors raise cash to meet redemptions. Wednesday's $2.449 billion of bids-wanteds is the highest level since March 2020, per Bloomberg data.
Interest rate risk is still high. Gastall said he is “very cautious” on interest rate risk in the current climate, and is using a premium bond strategy to mitigate that risk.
Gastall recommends above-market coupon structures, such as premium bonds that also offer tax efficiencies and creditworthiness, in the current market.
“Amid the broader rate stability, the fixed-income asset class pays a higher average market coupon, and is creditworthy and tax-efficient,” he noted.
He said laddering short-end maturities and working with a kicker structure works well with a flat yield curve and in a climate of possible further rising rates.
The creditworthy, high-coupon, short-call bonds offer a better yield to call in most instances, according to Gastall, who said if the bonds are not called, “the yield kicks up and keeps pace with or surpasses rising rates.”
“At the same time, if you’re talking about a very large coupon it's possible that the bonds will be called and rates will rise, but investors will earn a higher yield to the call than they would have to maturity and may be reinvesting at higher rates,” he added.
Going forward, he said investors should prepare for opportunities.
“As we head into the summer and fall, you want to keep some powder dry in case rates continue to rise,” Gastall said.
BlackRock said near-term performance will likely continue to be dictated by interest rates.
“However, we believe that municipals once again provide an attractive opportunity for investors,” they wrote.
Municipal-specific yields, technical market and credit-related indicators are creating an opportunity for income seeking investors to take advantage of, at least while it lasts, Kozlik said.
"In years past, there was only a very small amount of available supply of municipal bonds to choose from for fixed-income investors," Kozlik said. "Now, the high level of flows out of funds, and attractive municipal-specific yields offer an entry-point for income seeking and traditional municipal bond investors that does not present itself very often."
