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  • Jonathan Poyer

There Might Be Some Juice in Munis Afterall

A nice overview by our good friend Roberto Roffo from SWBC Investment Company:

President John F. Kennedy stated in his 1962 State of the Union Address that “The time to repair your roof is when the sun is shining.” regarding the management of the economy and keeping it healthy. Obviously, the Federal Reserve did not pay attention this insightful quote and its hesitancy to start raising interest rates when hints of inflation started, has only made matters worse.

Inflation is difficult to control once it begins and has caused historic volatility in the fixed income markets. Inflation has also caused havoc in the yield curve causing a massive inversion and leaving investors very confused.

All this uncertainty has resulted in both short-term and long-term yields increasing substantially and hurting many investors in the process. As painful as the increase in yields were, they have created unseen opportunities going forward and can lock in higher streams of income making investors optimistic for a long time to come.

While the Federal Reserve may not be done raising short-term interest rates, I believe the more they raise rates, the more damage will ultimately be done to the economy going forward. This scenario should cause the curve to invert further and offer investors a relative haven in long term bonds as short-term rates continue to increase (italics added). The short end of the Municipal yield curve could be even more susceptible than Treasuries as the massive cash flow into short-term Municipal bonds has left them extremely rich in historical terms.

Over the last 10 years Municipal bonds have traded at approximately 87% of Treasuries, due to the rush to perceived safety they are currently trading at 55% of Treasuries. This richness could cause short-term Municipal bonds to underperform as interest rates keep climbing.

The long end of the yield curve acts as a predictor for future economic activity and the current inversion is predicting a slowdown in the future. I believe that the longer the Federal Reserve embarks on their quest to raise short-term interest rates the more damage will be done to the economy. This scenario can cause an outperformance in longer dated securities and investors should consider locking in current longterm yields prior to the eventual slowdown in the economy and the Fed lowering short-term rates. Not only will this provide an income stream not seen in decades, but the market value of the bonds will also increase further as economic activity begins to weaken and interest rates begin to fall.

Source: Bloomberg

One last aspect for investors to consider is that unlike short-term bonds, longer dated Municipal bonds are attractive relative to their historical average to Treasuries. Over the last 10 years longer dated Municipal bonds have averaged approximately 85% of comparable Treasuries and are currently trading at 95%. This could potentially add another layer of return as they normalize.

Regarding the overall Municipal market, I continue to be optimistic as I was in my 2023 outlook. In general, states continue to have strong balance sheets, credit upgrades are far outpacing downgrades in all sectors of the market, and new issuance is on track to come in at the lower end of estimates. Additionally, 3 major investment companies have recently launched new Municipal products, strengthening my belief that there is value to be found in the current Municipal market.

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