- Jonathan Poyer
The Storm Clouds Are Clearing For The Municipal Bond Market
Without a doubt 2022 has been a disaster for the Municipal bond market so far. Historic losses and extreme fear of rising interest rates have driven investors out of the market in record numbers, exacerbating the problem even further. Interest rates have risen with the speed of lightning bolt and the once rosy outlook for the American economy has diminished with the onset of inflation not see in over 40 years (below YTD through 5/31/2022):
With all of the negativity the market has experienced, some professional investors are starting to see a light at the end of the tunnel.
Let us focus on the negative aspects first. The Municipal market experienced its worst start to a year in the history of the market which dates to 1812. Since the advent of the Bloomberg Municipal Bond Index in 1993, there have only been three times prior to 2022 where the market fell four consecutive months in a row. Municipal structured products such as Closed-end Funds have fallen as much as 30%, outpacing losses in the major equity indices. Investors have also withdrawn a record $70B! so far this year forcing even more selling by funds. From the ICI through May 2022:
This has led interest rates in the Municipal market to rise to the point where they are yielding more than taxable bonds and investment grade closed end funds having higher tax equivalent yields than corporate junk bonds.
If nothing else, the Municipal market is full of historical trends that keep repeating themselves time and time again. As mentioned, the market has never had five straight months of negative returns and while it seemed that 2022 would break that streak, the market rallied strongly during May resulting in a positive monthly return.
Since 1993 there have only been four negative calendar years for Municipal bonds, the worst year posting a -8% return. After each of those years the market had an average double digit positive return.
In more recent history, a study of five peak to trough drawdowns due to various factors like the mortgage collapse in 2008 to the COVID lock down in 2020, had an average drawdown of -8.22%. The following twelve-month period returned an average 12.88%.
Aside from the historical trends, economists are coming out daily predicting a slowdown in economic activity going forward due to the Federal Reserve raising short term interest rates and falling demand due to inflation. This type of economic environment typically leads to lower long term interest rates and a positive return for bonds.
The negative sentiment has created extreme value in the Municipal market and the potential for a positive price environment going forward. Investors who have been holding a shorter maturity, lower duration Municipal portfolio during 2022 may want to start shifting some of those assets into the longer end of the market to take advantage of the higher interest rates and the positive historical trends of the Municipal market. Investors who have been holding longer dated, longer duration bonds may also want to add positions at this point to lower the average cost of their holdings, take advantage of higher yields and potentially increase total return when yields start to fall again.