While there is despair in the...air, we see a few points of optimism relating to the muni markets:
Relative value vs. treasuries on the long-end of the yield curve
Tax-equivalent yields are comparable to or higher than corporates
Short-end has outperformed treasuries
The fixed income markets and in particular the Municipal bond market had another very difficult week and are still trying to find solid footing. Between an employment number that was slightly stronger than expected and inflation numbers that show inflation is not falling as quickly as expected, investors have been selling all fixed income investments furiously. While the adjustments to higher interest rates may hurt investors market values there are always positives that emerge from these types of vicious markets.
On a year-to-date basis the Municipal bond market is experiencing its worst year in history, with the Bloomberg Municipal index returning approximately -10%, the Bloomberg Long term Municipal index at -17% and the First Trust Municipal closed end fund index at -22%. These returns are disastrous for a market that has typically been a haven for investors in times of volatility. I don’t think there is a bond that has been issued in the last 12 months that has had a positive return and funds are awash in losses.
While there is a lot of bad news to digest, there are positive signs and opportunities in the Municipal bond market that cannot be ignored. The fundamental strength of Municipal bonds has been getting stronger with numerous rating upgrades in a difficult economic environment. The relative value of Municipal bonds versus Treasuries on the long end of the yield curve are extremely cheap and are offering absolute yields over Treasuries. Tax-equivalent yields are comparable to or higher than corporate bond yields. The short end of the Municipal bond market has outperformed Treasuries and while they are relatively expensive it has helped maintain a steeper yield curve aiding the funding of new purchases for some investors and adding to liquidity. One area that sticks out on the short end of the curve is Taxable Municipal bonds. While tax exempt municipal bonds are extremely rich and are not offering tax-equivalent yields comparable to Treasuries, taxable municipal bonds are offering yields significantly higher than comparable Treasury bonds. With the inversion of the yield curve, shorter dated taxable municipal bonds offer great value for income investors who are concerned about duration exposure. Finally, the Municipal bond market has had few negative calendar years in its history but has always strongly rebounded the following year after a negative one.
The Federal Reserve has left no doubt they will continue to raise short term interest rates until inflation is under control, and this will keep investors guessing until a clear path is in view. It is our view that the aggressive hawkish stance of the Federal Reserve will drive the economy into a deeper recession causing long-term interest rates to fall, further inverting the yield curve. Additionally, once the Fed announces a pivot form being overly hawkish, rates along the whole yield curve should fall precipitously.
Due to the relative cheapness of Municipal bonds compared to all other fixed income securities and the belief that it will be very difficult for the Federal Reserve to manufacture a soft landing, Municipal bonds should outperform in the next 6 to 12 months as interest rates start to fall again.
Indeed while the sun sets, the sun also rises:)