2022 Muni Outlook: Near-Term Pain, Longer-Term Opportunity

The imbalance may ease because of a slowdown in demand. If interest rates rise, as we expect, the pace of fund flows should slow and may even turn negative. We’ve found that when returns are negative, historically fund flows turn negative shortly afterward. In other words, fund investors experience price declines and then begin to withdraw money from those funds.

We expect interest rates to move higher next year as economic growth remains above its long-term trend and inflation remains elevated. We believe the 10-year Treasury yield could reach as high as 1.75% to 2.0% in 2022. Yields and prices move opposite one another, so if our expectation of higher rates comes to fruition, it could lead to near-term price declines.

A glass half full

A common metric to evaluate the relative attractiveness of the muni market is the municipals-over-bonds (MOB) spread. The MOB spread is a ratio of the yield on a AAA-rated muni relative to a Treasury bond of equal maturity before accounting for taxes. The MOB spreads for most maturities were historically low during most of 2021, especially for short-term maturities. This made it difficult for muni investors, because even after considering the effect of taxes, Treasuries and other highly rated investments often yielded more than munis, even for investors in the highest tax bracket.

The MOB spreads are below historical averages

If the supply-and-demand imbalance eases, as we expect it to do, MOB spreads should rise and yields for top-rated munis should move higher and closer to their longer-term averages. Spreads for lower-rated issuers should also rise, which would allow investors to achieve higher compensation for taking on credit risks.

No big tax hikes may lead to higher yields

To help pay for the Build Back Better spending package, Democrats originally had proposed increasing taxes on top earners, but as of this writing, many of those proposals were dropped. They could be added back in as negotiations move along but there is strong pushback against raising taxes. Among the original proposals were to increase the top tax rate to 39.6% from 37%, limit allowable deductions, levy a 3% surtax on individuals with an adjusted gross income above $5 million, and increase the top corporate tax rate to 26.5%. Municipal bonds generally pay interest income that is exempt from federal and potentially state income taxes. At higher tax rates, munis generally yield more than comparable taxable bonds like corporates or Treasuries.

The muni market responded to the prospect of higher taxes with yields moving lower relative to taxable alternatives as illustrated by the change in the “breakeven” tax rate. The “breakeven” tax rate is the tax rate at which a municipal bond will yield more than a corporate bond before adjusting for taxes. As illustrated in the chart below, this rate is currently 47.1%, meaning if an investor’s combined tax rate (federal, state, local, and other applicable taxes) is above 47.5%, munis yield more than corporate bonds after taxes. The breakeven tax rate is near the highs over the past decade. Since taxes may not rise as much as originally proposed, we would expect muni yields to rise and the breakeven tax rate to fall.

The breakeven tax rate is near 10-year highs

Concerns over credit should remain low

We have a positive view of the credit quality for most muni issuers. The current economic recovery, as well as the substantial fiscal support, have helped to bolster revenues for many muni issuers. As an example, the 50-state total of rainy-day funds was estimated to be higher in fiscal year 2021 compared to the pre-pandemic high according to the Pew Charitable Trusts. The improvement in credit conditions is reflected in muni upgrades and downgrades. For the past two quarters, credit rating agency Moody’s has upgraded more bonds than it has downgraded. In addition, defaults are relatively low and mostly occurring in the riskier parts of the muni market, such as unrated issuers, land-secured deals, and health-care and hospital facilities.

Muni defaults have been relatively low

In 2022, we anticipate that credit conditions will remain favorable for most municipal issuers and defaults should continue to remain low. Revenues have surged, led by an increase in corporate and income taxes. Greater revenues allow issuers greater financial flexibility. Moreover, the improving property market should benefit local governments, as property taxes tend to be their largest source of revenues.

Tax revenues have surged since Q4 2011

In addition to the improving revenue picture, funded levels for state pension plans are improving as well. According to projections by The Pew Charitable Trusts, “state retirement systems are now over 80% funded for the first time since 2008.” This is notable because an 80% funded level is considered to be fully funded. However, funded ratios vary by state, with some states like Illinois, New Jersey, and Kentucky largely lagging others.

What to do now

We expect 2022 to be characterized by some volatility but ultimately better investment opportunities than so far in 2021. We would suggest investors target a below-average duration, because bonds with lower durations typically experience smaller price declines to rising interest rates. A bond ladder strategy can be appropriate, because it can take the guesswork out of trying to time interest rates.

Given our positive view of credit quality, we suggest that investors moderately add some lower-rated issuers to their portfolios. Valuations are more attractive in the lower-rated portion of the muni market. Although we think that it’s appropriate to add some lower-rated issuers, we would caution against adding too much as they are still prone to more volatility relative to higher-rated issuers. As a rough starting point, we would suggest putting no more than 40% of a muni portfolio in BBB/Baa and A/A rated issuers. That could be further broken down by 10% to 15% BBB/Baa and 25% to 30% A/A. Consider these weightings a rough starting point and deviate from them based on your own personal risk tolerance and needs. For reference, the Bloomberg Muni Bond Index, which is a commonly tracked index for the muni market, is 16% Aaa, 50% Aa, 26% A, and 9% Baa.

¹ As of November 17, 2021.

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