A post from SWBC's Roberto Roffo:
The first half of 2023 proved to be a challenging environment for the municipal bond market as investor angst over the aggressive tightening by the FOMC, stubborn inflation and continued strong employment numbers resulted in extreme volatility.
Additionally, investors withdrew approximately $10 Billion from the market on top of the $140 Billion that fled the market in 2022. While all these factors were decidedly negative for the market, according to the Bloomberg Municipal bond index, municipal bonds were relatively flat with a return of -.10%.
With the volatility and some of the uncertainty behind us, there are many indicators that the second half of the year has the potential to post significantly better returns. The FOMC is close to ending their aggressive cycle of tightening, removing the upward bias in rates. Municipal bonds are relatively attractive to Treasuries as the ratio of tax-exempt yields versus taxable yields across the entire curve have cheapened substantially.
New issuance this year will be lower than average and should result in a demand/supply imbalance. Finally, yields on many municipal bonds are substantially above equivalent maturity Treasuries, with tax-equivalent yields as high as 300 – 400 basis points above Treasuries and significantly above the current inflation rate.
The two economic indicators which should add the most to a positive market will be inflation and the employment numbers. While there may still be some lag from the inflationary pressures we have experienced, inflation has been on a downward slope and as the rate hikes start to take hold, the decline should accelerate.
The non-farm payroll numbers over the last year have been impressively strong but they are also a lagging indicator and should soften going forward due to the aggressive Fed actions.
Credit strength is another strong positive, as there have been a substantial amount of upgrades and relatively few downgrades over the past year. Investment grade municipal bond credit has typically weathered downturns in the economy well and with the current strong balance sheets of most investment graded issuers the next downturn in the economy should be no different.
With all the positive indicators and the higher overall yields, I believe the market has created a favorable entry point for investors looking to increase income with the potential of long-term capital appreciation.