As investors continue to contemplate the effects of volatility and tightening monetary policy across asset classes, municipal bonds could be buttressed by traits that have helped them outperform during past periods of rising interest rates.
Financial markets have endured a tumultuous start to 2022, with volatility likely to remain a threat in the months ahead amid heightened geopolitical uncertainty and persistently elevated inflation. That aligns with PIMCO’s Cyclical Outlook, “Investing in a Fast-Moving Cycle,” which examines how the current economic cycle has been unusually rapid. Markets appear to be transitioning toward late-cycle dynamics as the Federal Reserve begins raising its policy rate to tame inflation.
In recent history, tax-exempt munis have exhibited resilience relative to other fixed income assets both when the Fed has raised rates and when the 10-year Treasury yield has risen significantly. Munis have also demonstrated a low correlation with equities and other risk assets, which may offer diversification attributes to portfolios.
Municipal credit fundamentals are expected to retain recent positive momentum, as state and local government coffers have recovered from pandemic pressures with the help of federal aid. There are also technical tailwinds supporting the muni market, such as expectations that the pace of maturing muni bonds will outstrip new issuance this year.
Municipal bond funds have been mired in a period of outflows amid the market volatility that has defined the early months of 2022. That dislocation is creating opportunities for active management and has provided a more attractive entry point for investors in terms of potentially higher after-tax yields.
Recent declines improve technical backdrop
Like stocks, bonds, and other assets, munis have been hit hard by volatility to begin the year, which came after the muni market entered 2022 with exceptionally rich initial conditions that became the primary drivers of weakness. Tax-exempt munis endured the worst January performance since 1981, with the investment grade muni index declining 2.74%, and the high yield index falling 2.80%, according to Bloomberg data.Footnote[i] Investors pulled $12.4 billion from municipal funds in the first two months of the year, according to Lipper data.
High-grade tax-exempt munis now appear to be back to levels suggesting long term fair value, as measured by the after-tax pickup versus comparable corporate bonds and by muni-to-U.S. Treasury yield ratios. These ratios suggest the muni market has cheapened, providing a more attractive entry point to invest.
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Limited supply will help support the tax-exempt muni market through the balance of 2022. Municipal issuers will continue to rely on taxable refinancings, as opposed to tax-exempt advance refundings, due to tax-law changes in 2017. While the taxable muni market should continue to grow, 2022 will likely be another net negative supply year for tax-exempt municipal bonds.