2022 Municipal Bond Outlook: Views on Rates, Fundamentals and Infrastructure
- How do you expect the municipal bond market to respond if US rates continue to move higher? Are you concerned about fund outflows?
The municipal bond market has historically outperformed relative to Treasurys during periods of rising interest rates. We expect that to happen again, but there are two factors in today’s environment that could mute that historical advantage, and both are related to the 2017 Tax Cuts and Jobs Act (TCJA) legislation.
- Valuations: Municipal valuations, as measured by yield ratios, are currently richer than their long-term historical valuation ranges compared to Treasurys. The TCJA prohibited tax-exempt advance refunding, which resulted in a permanent downdraft in tax-exempt issuance. Since then, the tax-exempt market has operated under supply-constrained conditions, and investors have pushed valuations higher. Rich valuations might not provide as much cushion to absorb the impact of further rate market moves if yields continue to move higher.
- Refunding: The municipal market is typically highly sensitive to supply. Refunding supply tends to increase when interest rates decline and decrease when rates rise. Historically, this has helped dampen relative municipal market volatility in bull and bear market scenarios. However, refunding supply is now transmitted solely through taxable municipal issuance, so the expected dampening effect would not impact the tax-exempt market.
With the Federal Reserve on track to begin raising rates in 2022, we would expect demand from fund investors to be more volatile. However, we believe greater volatility can result in increased opportunities for active investment strategies. Greater two-way market flow could present opportunities for portfolio rebalancing and managing unrealized gain/loss positions. It could also provide more liquidity for forced sellers than would otherwise be the case.
- What are your expectations for municipal bond supply in 2022? Could the new federal infrastructure program inject some new issuance into the market this year?
In our view, issuance should expand this year, but perhaps not as robustly as we had anticipated early in 2021. Federal infrastructure legislation failed to include provisions for direct-subsidy taxable municipals or a restoration of tax-exempt advance refunding. Nevertheless, we believe the $1.1 trillion Investment in Infrastructure and Jobs Act (IIJA) should result in companion issuance from state and local governments for capital projects that complement direct federal investment. In addition, the IIJA covers funding for basic infrastructure needs, which should provide state and local governments with greater flexibility to invest in other infrastructure needs. At the margin, we expect the IIJA will generally have a positive impact on supply, but it may take some time for projects and issuance to get underway. However, if rates move higher or faster than anticipated, taxable issuance could decline.
