The second quarter should bring more opportunity and less volatility on the heels of the first quarter’s underperformance and poor market technicals, municipal experts and analysts say.
“We think munis are extremely well positioned to outperform Treasuries in quarter two,” said Ben Barber, director of municipal bonds for Franklin Templeton Fixed Income. “First quarter 2022 was the worst calendar quarter for muni returns since the ‘80s, and we’re in one of the best credit fundamental environments in quite some time.”
Muni underperformance at the high-grade level was very “severe” in the first quarter, and credit spreads widened, especially on the more liquid names where prices can reflect actual trading levels much more closely than less liquid bonds, Barber said.
With the second quarter just under way, municipal analysts offered some early observations that include everything from higher yields and better performance to stable credit quality and attractive interest income.
Anthony G. Valeri, director of investment management at Zions Wealth Management in San Diego, expects to see noticeable improvement after a historically bad first quarter.
Municipals underperformed Treasuries in the first quarter 2022 and valuations cheapened to their most attractive levels since late 2020, Valeri noted.
Now, the 10- and 30-year average triple-A municipal yields are close to those of comparable maturity Treasuries.
“April may bring renewed focus from foreign investors, which may help bonds broadly,” Valeri said.
The start of a new fiscal year in Japan, and potential buying interest, has often supported the broad U.S. bond market in the past, he added.
While bond volatility likely stays high in the second quarter, Valeri noted, quite a bit of that is already priced into the market and should not create added pressure.
“The bond market has priced in an additional 2% worth of Federal Reserve Board rate hikes for 2022 and roughly three more 0.25% rate hikes in 2023,” Valeri said. “Since so much is priced in, I think prices moderate here. And while yields may drift higher, I think interest income offsets price declines.”
Due to stimulus and the strength of the economic rebound, municipal credit quality remains very strong, Valeri noted.
Generally, the municipal market should take its price cues in the current quarter from the Treasury market, said Wesly Pate, senior portfolio manager at Income Research + Management.
One of the key positive market technicals is the relative steepness in the municipal curve relative to the Treasury curve, Pate said.
The municipal five- and 10-year curve remains reasonably upward sloping compared to the same part of the Treasury curve that is currently inverted, he noted.
“Municipal curves rarely invert given very different buying patterns versus the taxable market and we expect this positive slope to both gather greater interest from investors and potentially push investors to favor more duration in the asset class,” he said.
Pate expects municipals to fare slightly better than Treasuries in quarter two given an attractive starting point in terms of relative valuations.
“Favorable fundamentals linked to the strong credit profiles of most municipal borrowers and steady technicals driven by consistent issuance themes leaves the market on a solid footing to start the quarter,” Pate said.
“With yields higher today, we expect selling pressure to subside and potential inflows to slowly begin as higher rates will garner additional interest in the asset class,” Pate continued.
Starting yields are the greatest determinant to the advantage an investor wields in fixed income, he noted, saying yield is like having insurance against negative returns as it serves to mitigate some of the adverse pricing pressures that come with rising rates.
“Higher yields in the triple-A curve, coupled with modestly wider credit spreads, offer a greater entry point into the asset class and offer more of an advantageous starting point than what we have seen in recent years,” Pate said. “Excluding the short-lived pandemic level yields we saw in early ’20, today’s yields are the highest we’ve seen since early 2019."
Negative fund flows have pushed up the municipal-Treasury ratios to highs above the 10-year average, said Peter Delahunt, director of municipals at global fixed income firm StoneX.
“As we know, Q1 was the worst quarter for munis in 40 years,” as municipal bonds were off 6.8%, he said. “Entering quarter two, we'll need to see positive fund flows for our market to stabilize."
The persistent outflows in the first quarter have resulted in strong selling pressure as evidenced by the elevated levels of bid-wanteds.
In addition, supply is expected to grow at the same time the market is seeing a departure in demand, leading to the weak and unattractive technicals, he added.
“Meager principle and interest rollovers of $22 billion in April will be of little help to demand,” Delahunt said. “It's not until late in Q2 that the rollovers pickup substantially in June and continue into July and August, running over $44 billion per month,” which should fuel demand, he said.
“While funds and other surrogate retail vehicles, ETFs and SMAs are the 300-pound gorilla in the muni demand universe, the cross-over demand has reared its head from a long, dormant slumber,” Delahunt said.
Meanwhile, the higher-yield climate is impacting demand and investor interest, the analysts said.
“Yields have increased a lot and that will draw the attention of investors,” Valeri said, noting that 10-year triple-A municipals offer a greater than 4% taxable equivalent yield to top tax bracket investors.
“Given the macro uncertainties still lurking, it will prove attractive to many investors,” Valeri said, adding that mutual bond fund selling pressure will subside.
Delahunt said municipals currently offer more attractive yields than taxables on an after-tax, grossed up basis in the intermediate part of the curve and higher outright yields on the long end.
“More cross-over demand will temper the weakened fund demand, prompting stability, which could mitigate further outflows,” Delahunt said. “All this leads to more optimism as the market moves into the latter half of Q2.".
Like Valeri, Sean Carney of BlackRock Inc. believes volatility will likely ease, given how interest rates have risen and the risk that has been recalibrated during quarter one.
“Much like quarter one where municipals were directionally driven by three key factors, the asset class will be subject to the overall rate backdrop as the Federal Reserve Board continues to hike interest rates while shrinking their balance sheet,” Carney said.
“Our key theme of being patient in quarter one while awaiting a better entry point was correct, but now it’s time to become more involved as, historically, selloffs such as the one we recently experienced, have proven to be very good buying opportunities for longer-term investors," Carney said.
During the second quarter, he anticipates a more balanced marketplace with better two-way flow creating good opportunities in both the primary and secondary.
“While headwinds may not become immediate tailwinds, it does feel as though headwinds are subsiding, which will help break the back of the negative feedback loop the market is currently experiencing, where rate volatility creates negative performance, which leads to outflows,” Carney added.
During quarter two, investors will be looking for clues from both the Federal Reserve and economic data on the future health of the economy, he said.
“Surging inflation, stagflation and recession concerns all make great headlines, but what is the probability they take center stage in 2022, while the Fed is active both on the rates side of the equation and the balance sheet?” Carney asked.
Carney said the advantage investors in the second quarter have is simply the result of a market that has repriced and offers a much less risky entry point than it has during the past year.
“Ratios are significantly higher across the curve after remaining at unsustainable levels throughout 2021, yields are higher, spreads are wider, and the buyer base deeper as a result,” Carney said.
BlackRock favors intermediate maturities given that 86% of the full yield curve can be captured by extending out just 10 years, he said. “We prefer an up-in-quality bias overall with a neutral allocation to non-investment grade bonds.”
While the analysts see many opportunities, there could be some pitfalls investors will be wary of in the second quarter, municipal experts said.
“Given the strong credit fundamental environment, investors will definitely be looking out for any difficulties with the budgeting process at the state and local level,” Barber said.
Some concerns for investors include: will states get locked into spending patterns that aren’t sustainable with a slight slowdown in tax receipts, and will inflation impact budgets from the revenue or expenditure side.
In addition, investors will increasingly exhibit caution in lower-coupon bonds, Pate said.
“Falling through the de minimis threshold has either already occurred for some bonds, or is a greater risk today than in recent years for 3% and lower coupons,” he suggested, pointing to the near-term potential volatility in par-priced housing bonds to be most pronounced as many recently issued securities are now priced below the de minimis threshold.
An increased market focus on liquidity amid recent outflows could put modest, incremental downward pressure on these securities, Pate said.
“Starting valuations are far more attractive today than where we started the year,” he said. “If your time horizon exceeds your duration you benefit from rising rates as eventually the reinvestment at higher prevailing rates becomes incrementally more accretive.”
Toward the end of the second quarter, market technicals will likely tilt more positive for investors in the form of substantial reinvestment needs due to maturities and coupon payments, Pate added.
There could be much less pressure on the Treasury market in the second quarter given how much reaction to inflation “surprises” have already been put into place, according to Barber.
Another difference is muni-Treasury valuations, he added.
“At the beginning of the year, the 30-year muni/Treasury ratio was 76%. Today it is 106%,” Barber said. “The amount of cushion that the muni market now has relative to Treasuries is clearly an advantage."
Investors with flexibility from a credit and duration perspective will see advantages in the second quarter, he said. “The muni market has just gone through a very significant repricing, on both muni/Treasury ratios, as well as credit spreads.
“Given the inefficiency of the muni market, there will continue to be very good opportunities for quite some time,” he added.
Some of the economic impacts the municipal market will face in quarter two will stem from the conclusion of budget season, according to Barber.
“We expect states to still show strong fiscal year ‘22 results, but fiscal year ’23 budgets could look different than projected, with inflation impacting both revenues and expenditures,” he said.
Overall on the supply front, Valeri expects new issuance to remain very light, while state and local finances remain strong, with a reduced need to issue debt.
Meanwhile, the prospect of tax hikes — a positive catalyst for municipals — seems to be fading, Valeri noted.
“There are roughly three to four months left for Congress to do something before summer recess and then attention shifts to mid-term elections,” he said, . Democrats can’t muster a majority to pass tax increases.
“This will be increasingly difficult with gas prices and inflation elevated,” he continued. A tax increase, if any, will be limited and not impact the majority of municipal investors, according to Valeri.
Although June has traditionally been a “challenging” month, the impact has faded in recent years, he noted.
Others agreed performance and yield opportunities will be ripe in quarter two versus the first three months of the year.
“Once we get past tax time, seasonals turn more positive,” Carney said. “In an environment where rates stabilize, munis should perform well given the year-to-date underperformance we have experienced, and the all-in yield opportunity not seen in quite some time."
