As investors look at the carnage of 2022 in the rear-view mirror, 2023 may provide sunny days ahead for Municipal bond investors.
The aggressive increases in short term rates by the Federal Reserve are almost done, inflation seems to have peaked and although still too high, has a downward trajectory.
Economic indicators are also moderating, which should add to the positive environment for fixed income. In addition to these factors, the Municipal market has some added reasons to believe that 2023 will be a positive year. Once again, new issue supply should be lower than average and will probably not be enough to replenish the amount of bonds that are maturing and the expected coupon reinvestment. Add in the expected positive cash flow from investors and the environment for Municipal bonds looks positive for 2023.
While the depth of the expected economic slowdown in 2023 can be debated, most economists are predicting a recession. While it’s too soon to predict whether the recession will be deep or a soft landing, one thing is for sure, slower economic activity should lead to lower long term interest rates. Inflation can be a sticking point for lower rates as it has been stubbornly high, but looking at the trend, one can see a definite peak and a gradual reduction in the overall rate. If this continues in 2023 it will be another positive for the overall bond market.
The environment for the Municipal bond market in 2023 is even better than the overall bond market as there are many factors that should lead to Municipal bonds outperforming taxable bonds. As overall interest rates trend lower, Municipal bonds should follow but with the ratio of tax-free yields at or above 100% of taxable yields, Municipal bonds should outperform their taxable counterparts. The average ratio over the last 10 years excluding the covid period has been approximately 88%, even if taxable yields remained flat for the year, a decrease in ratios to more normal levels would result in significant outperformance for Municipal bonds.
While estimated new issuance of bonds varies widely, major banks are expecting an average of $400 Billion in new bonds in 2023 versus $350 Billion in 2022. If projections are correct, the new issuance will not be enough to cover the expected $525 Billion of maturing bonds and coupon reinvestment. Adding in an expected turnaround from the record $125 Billion in redemptions of 2022, even a slightly positive cash flow from investors could exacerbate a move to lower yields and higher prices.
Credit fundamentals for the Municipal bond market remain strong as states and local government balance sheets are still positive due to covid relief money and generally higher tax revenues. This leaves most issuers in good shape to weather the storm of an expected recession. Municipal bonds already have the lowest default rate of any other fixed income asset class other than Treasuries and I would expect that to remain the case in 2023.
Municipal bond market history is also a good indicator for predicting positive returns after a negative year. Analyzing the last five peak to trough drawdowns, from the subprime mortgage collapse in 2008 to the covid 19 pandemic of 2020, the Bloomberg Municipal bond market index has averaged -8.22%, with the following 12 months returning an average positive return of 12.88%. Over the same time periods, other indices which are more indicative of long-term funds had significantly larger drawdowns and positive returns. The Bloomberg Long-term Municipal index had an average drawdown of -13.44% with the following 12 months returning a positive 19.95%. The average recovery rate for the following 12 months after the low in returns is approximately 150% for both indices. Utilizing these averages as predictor of returns in 2023, the Bloomberg Municipal bond index would have a return of 12.05%, which is extremely close to the Bank of America prediction of 11.50%. Following the same trend, the Bloomberg Long term Municipal index would have a return of 21.63%.
While not exact science, this history gives us another indicator that 2023 should be a better year for Municipal bonds.
There is no doubt that 2022 will last in the memory of investors for a long time to come, but from the ashes of the historic meltdown many opportunities have been created and these opportunities allow us to be optimistic for the year ahead.
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