Reasons to be optimistic:
There are various reasons why we feel investors should be optimistic about municipal debt in 2023. First, with the yield on The Bloomberg U.S Municipal Index at 3.54% to start the year investors are being compensated with the highest tax-exempt yields in over 10 years. Also, if history is a guide muni bonds tend to perform favorably following a year of negative returns, as was the case in 2022. In fact, since the inception of the Bloomberg Barclays Municipal Bonds Index muni bonds have experienced consecutive years of negative total returns just once (1980-1981). In years following a negative total return, the asset class has generated an average of 18.39% in total return. Lastly, municipal fundamentals remain very strong and are positioned well headed into a potential economic slowdown.Chart 1: Investment grade muni total return after down years (as of 01.11.23)
Source: Bloomberg, the Bloomberg U.S Municipal Index 1.11.23
While the municipal bond market finished 2022 with positive momentum that has continued into early 2023, there is reason to be cautious as well. The Federal Reserve is expected to further tighten interest rates another 50bps in the first quarter, which could put upward pressure on yields in the short term. Inflation remains the biggest concern for policy makers, with headline inflation at 6.5% and core inflation at 5.7%,2 although those numbers have been trending down recently. This high inflation has contributed to an extended period where real yields in munis and fixed income have remained negative. Should inflation remain elevated, this could cause investors to rethink whether they are being adequately compensated in real terms despite high nominal yields, thus putting further upward pressure on yields. In addition, investors should be cautious given where muni yields currently are relative to taxable yields. Following the rally over the past couple of months, muni ratios (muni versus taxable) look rich at 60%, 65%, and 88% in the respective five-, 10-, and 30-year parts of the curve.3 With long-term ratios averaging well above where they are priced currently.
Where to position your muni bond allocation in Q1 2023?
Given our expectations for rates to remain elevated at the front end, and uncertainty around inflation and longer-term interest rates in the medium to long term, we caution investors from extending in duration at the moment. The continued strength of the labor market has potentially pushed back the prospect of a recession and minimized potential Fed rate cuts that appear priced into markets. If we assume a recession is coming in 2024 versus 2023, this would keep rates elevated for longer as the Fed has no reason to pull back the reigns in its fight against inflation until the labor market shows signs of waning.
While the muni bond market is experiencing some short-term technical tailwinds given the dearth of municipal issuance and coupon payments and maturities in January, there is a good probability this tailwind subsides as issuers come to market in the second half of the quarter. Therefore, for investors looking to maximize yield we believe staying short in duration and/or implementing a barbell strategy is the proper strategy given the shape of the yield curve (see chart 2). Most important, as we get into the mid-first quarter, we think investors should beware the belly.
Chart 2: AAA Muni Curve (as of 1/31/23)
Source: Bloomberg,BVAL Muni AAA Yield Curve 1.31.23
- Bloomberg BVAL Muni AAA Yield Curve, The Bloomberg U.S Municipal Index
- The US Bureau of Labor Statistics
- Bloomberg, BVAL AAA Muni Yield % of Treasury 5 Year, BVAL AAA Muni Yield % of Treasury 10 Year, BVAL AAA Muni Yield % of Treasury 30 Year