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Municipal Basis Points 3Q2022: Have Yield, Will Travel

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Municipal Basis Points

3Q 2022
Have Yield, Will Travel
Municipal bonds experienced a difficult first half, but now have much more to offer investors. Yields have generally more than doubled since January 1, greatly enhancing potential income, while value relative to Treasuries has become more compelling—essentially providing the municipal tax exemption for free. That said, market volatility is likely to be elevated moving forward, making fundamental analysis and security selection especially important. Read more of our views in this report.
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Overview
“There is nothing so stable as change.”

– Bob Dylan

For municipal investors, recent market volatility may clear the way to greater opportunity.

After an extremely difficult start to the year, municipal bonds continued their decline in the second quarter, albeit at a slower pace. The full investment-grade municipal market, as measured by the Bloomberg Municipal Bond index, declined by 2.94% in the quarter, bringing its year-to-date return to -8.98%. Lower-rated bonds, which had performed more in line with higher-rated securities at the beginning of the year, meaningfully underperformed in the second quarter. The biggest driver of continued volatility was the persistence of highly elevated inflation readings and the market’s constant repricing of how aggressive the Federal Reserve will need to be in order to bring inflation back down. We recognize that the Fed’s job right now is extremely challenging as it tries to pull off a soft landing by reducing inflation while avoiding a meaningful economic downturn. Chairman Jerome Powell didn’t help his cause by saying that a 75-basis-point rate increase was “off the table,” only to quickly reverse course and move by that amount at the Fed’s June meeting. For years, the Fed has conditioned the markets to value clear communication. This type of uncertainty is only adding to the volatility in rates and markets overall.

Many investors were frustrated that fixed income failed to serve as ballast to the volatility in other asset classes in the first six months of the year. That said, higher-quality short to intermediate maturity municipals were only down a fraction of what was experienced in equities and other risk assets. We recognize how challenging returns have been, but we think it’s very important to consider what municipal bonds have to offer going forward. Yields have generally more than doubled since January 1, so the income cushion provided by municipal bonds is much more attractive than what existed at the start of the year.1 Relative value has also improved, as the ratio of 10-year AAA municipal yields to comparable Treasuries has gone from around 70% to 93% as of June 30. In effect, investors are getting the value of the tax exemption almost for free. Spreads on lower-rated investment grade munis have moved wider, and are now more reflective of their differentials in credit risk relative to higher-rated bonds. Finally, while credit quality has probably peaked, we enter this period of slower economic growth with fundamentals on a fairly solid footing due to strong growth last year and generous fiscal support throughout the pandemic.

Going forward, we think the above factors should lead to improved return potential for the municipal asset class given the yield cushion that now exists due to the higher rate environment. We favor a more up-in-quality approach as volatility should remain elevated and higher-rated bonds now offer much better relative value than at the beginning of the year. Floating-rate securities are interesting as their yields can benefit as the Fed continues to raise rates. Finally, a market with highly elevated volatility is much more favorable to our approach to investing, which focuses on security selection. The days of the “tide lifting all boats” is most definitely over, which is not a bad thing in our view. By its nature, the municipal market is large and fragmented given the sheer volume of issuers that come to market. We believe that analyzing the fundamentals of an investment and then deciding whether it is priced appropriately is going to drive returns going forward, now that the Fed is pulling back on the throttle.

Second-Half Playbook: Cautious Optimism
"My dog is worried about the economy because Alpo is up to $3 a can. That’s almost $21 in dog money."

– Joe Weinstein

Bad news for the economy could be good news for munis.

Ten-year U.S. Treasury rates have resembled a rollercoaster ride since mid-May, rising to around 3.5% after a 8.6% Consumer Price Index print, and falling back to 2.8% as the market began to question future growth. These rate moves highlight recent Treasury volatility, and municipals have been taken along for the ride.

On the heels of a higher-than-expected CPI release, the Fed surprised some market participants in June by raising rates 75 basis points in an effort to aggressively fight inflation. Prior to this news, market participants were pricing a potential September pause in the hiking cycle, which now seems highly unlikely. This reflects an ongoing “tug-of-war” for the Fed, pitting its determination to achieve price stability against the potential that its actions will mean substantially lower growth.

Despite increased rate volatility, however, the municipal market is arguably in a better position. Recently, municipals have seen strong demand pushing tax-exempt rates lower; mutual fund outflows have slowed; and large amounts of cash from summer redemptions (maturities and coupon payments) have been returned to investors. Most of this cash is being reinvested in the marketplace, further supporting demand.

As we enter the second half of 2022, potential bad news for the economy could be good news for municipal bond prices. We believe that market participants can still purchase high-quality bonds at compelling entry points with added potential for price appreciation. We continue to focus on securities with strong fundamentals and remain active in taking advantage of opportunities in the marketplace.

On the Rollercoaster
U.S. Treasury Yields
U.S. Treasury Yields
Source: Bloomberg. Data through June 30, 2022.
Assessing the Fed’s Shrinking Balance Sheet

Inflation, now at a 40-year high, has dulled the focus on the Fed’s bloated balance sheet, which, at $9 trillion, has more than doubled in size since the start of the pandemic. To recap, the Fed purchased $120 billion per month monthly ($80 billion in U.S. Treasuries and $40 billion in mortgage-backed securities) from March 2020 to March 2022 in a process known as quantitative easing, leading to a large increase of “cheap” money in circulation. This unconventional policy tool enabled the Fed to stimulate the economy after interest rates were already at zero, effectively guiding U.S. Treasuries and mortgages to record low rates.

In September, the central bank plans to ramp up its balance sheet reduction to $1 trillion annually, a goal that is already priced into the market. We have a cautious view of adding meaningful duration, however, as the Fed could increase the amount of quantitative tightening in future meetings. Should this occur as global central banks are simultaneously removing stimulus, longer-term U.S. Treasuries (and by extension other sectors, including municipals) could experience bouts of increased volatility.

And Lastly…Tax-Loss Harvesting

For most of this year, we have watched rates move higher and bond prices fall as the Fed has combatted inflation. A major benefit afforded to investors in separately managed accounts is the ability to harvest tax losses. Taking losses in municipal bond portfolios generally allows investors to offset tax liabilities arising from capital gains in other asset classes. Historically in a year-end process (although it can take place at any time), some investors may seek to actively sell bonds trading at a loss while purchasing similar maturing bonds of comparable credit and yield. This swap strategy is designed to leave the portfolio in the same general position but create a usable loss for tax purposes, if desired.

Investment Outflows May Be Moderating
U.S. Municipal Market Fund Flows ($ Billions)
U.S. Municipal Market Fund Flows
Source: Lipper.
Fundamental Focus: The State of the States
“Happiness is a state of mind.”

– Walt Disney

‘Goldilocks’ conditions for state finances have likely peaked.

As fiscal 2023 begins for many states on July 1, state budget discussions have been focal points in legislatures across the nation. The financial position of most states in fiscal 2022 was favorable in the aftermath of significant federal aid due to the pandemic, as well as tax receipts that exceeded budgeted expectations. According to the National Association of State Budget Officers, 49 states reported fiscal 2022 revenues in excess of budgeted levels while no states reported the need to make midyear budget cuts due to revenue shortfalls. While some states did actually implement spending cuts at midyear, this was due to fewer spending needs or the use of federal aid instead of state general fund sources. Additionally, some states actually increased spending at midyear due to operational surpluses.

An additional benefit of these favorable financial results has been the growth of “rainy day” fund balances at the state level. The average reserve account continued to grow in fiscal 2022 after a 62% increase the prior year, and is projected to account for approximately 11.4% in fiscal 2023. In prior years, diminished reserve levels were a significant weakness as they limited financial flexibility and contributed to often prolonged and difficult budget negotiations.

Despite the recent budgetary strides, increasing risks of an economic slowdown and/or recession are likely to affect state revenues, accompanied by growing expenditure costs. As such, we believe that state finances have likely peaked and could experience increased pressures in 2023. The impact of global events, inflation and a domestic economic contraction are being factored into fiscal 2023 budgetary projections. A hawkish Federal Reserve, which is expected to significantly increase interest rates several times before year-end, is likely to have a negative impact on both personal and corporate spending. If this leads to significant economic slowing, that could decrease consumption and increase unemployment. As per the Tax Policy Center, for fiscal 2023, personal income tax collections are expected to increase 0.4%, with corporate income tax revenues declining by 8.6% and sales tax revenues only growing by 1.9%. These levels would be down significantly from fiscal 2022.

State Revenues: Strong but Likely to Fade
Actual and Forecast State Revenue Growth
Actual and Forecast State Revenue Growth
Source: TaxVox, as of April 19, 2022.

Current uncertainty around the economy is helping to drive market volatility. While many economists continue to debate whether the Fed can safely land the economy without triggering a recession via its use of monetary policy, most forecasters believe the economy is likely to slow. As such, prudent budgetary assumptions are likely to be even more important for fiscal 2023. Negative returns in equity markets could be an additional source of fiscal pressure for some states, as they affect personal income tax receipts. During years of strong equity market performance, capital gains tax revenues have often helped buttress tax inflows, as has been the case for California in recent years, for example. With about two-thirds of the state’s revenues coming from personal income tax receipts (as per the governor’s 2022 – 23 budget report), this concentration risk may pose budgetary risk going forward.

California’s Personal Tax Risk
State Revenues by Source
State Revenues by Source
Source: State of California budget summary, 2022 – 2023.

Looking ahead, we believe a slowing—as opposed to a sharp drop—in state revenues is the likely course over the next several months. However, the duration and magnitude of this trend is uncertain and will likely depend on many variables, including inflation expectations, actions by the Fed, personal spending and overall consumer sentiment. What’s more certain is that the recent “Goldilocks” scenario for state budgets and finances has likely peaked, portending more challenging days for some states in fiscal 2023.

OUTLOOK
Municipal Basis Points 3Q 2022
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