There should be less concern over interest rates and inflation and more optimism over credit quality and returns in the second half of 2023, municipal experts said.
While investors will still keep inflation and the Federal Reserve Board’s policy decisions on their radar screens, overall market technicals are expected to appeal to investors before year end, sources said.
“The first half of the year was dominated by the debt ceiling, worries over the banking sector, and concerns about how high and fast the Fed might have to hike rates,” said Cooper Howard, director of fixed income strategy at the Schwab Center for Financial Research.
Municipals boast strong long-term fundamentals, such as tax-advantaged income and high credit quality, according to Howard.
The biggest advantage heading into the second half is that yields have moved up quite significantly from almost two years ago and are now at the point where they’re attractive relative to alternatives, Howard said.
Strong performance and less volatility than other markets should continue into the second half, according to Daniel S. Solender, a partner and director of tax-free income at Lord Abbett.
“Returns were relatively good during the first half, so investors should be feeling better about the municipal market than they did at the end of last year,” he said.
The Bloomberg Municipal Index is returning 0.72% in July and 3.41% year-to-date, while high-yield is returning 1.05% this month and 5.53% so far this year. Taxable municipals are down 0.09% in July but are in the black at 4.66% year-to-date.
Solender echoed Howard’s suggestion that municipal rates are at more attractive levels than they have been in years.
“Investor demand should increase as they get more comfortable with the overall rate environment,” he said last week.
Solender also expects to see less pressure on the market as concerns over inflation and Fed rate hikes decrease.
“As long as the current trends remain in place, those concerns will move lower as we get further into the year,” he said. “This will help investors become more comfortable getting out of T-Bills and investing in longer maturities,” such as municipals.
“If investors believe the Fed is done, there will be a spike in demand as they look to restructure portfolios for the long term in the face of low supply,” Roberto Roffo, managing director and portfolio manager at SWBC Investment Company, said. “If the Federal Reserve indicates they may not be done, then the volatility witnessed in the first half of the year should continue, but with the municipal market outperforming due to the relative cheapness and low supply.”
Roffo also suggested that investors should in the second half take advantage of the current yield compensation before muni interest rates potentially fall.
“While ratios may be at fair value on the long end of the curve, stepping down from triple-A bonds to double-A or even single-A-rated bonds offers great value versus taxable bonds while adding minimal credit risk,” he said. “The excess yield gained equated to approximately 300 to 400 basis points in tax-equivalent yield, which would be about double Treasury yields.”
Howard said yields for highly rated municipals remain low versus alternatives, and agreed with Roffo that the more attractive part of the market is double-A and single-A-rated issuers in the five to seven-year slope of the yield curve.”
“The muni-to-Treasury ratio is low compared to historical averages and may be a headwind to performance longer-term,” Howard said.
A tailwind for the market is that credit quality remains strong, Solender said.
“Credit has been outperforming this year and as a recession continues to appear less likely, that should provide further support for lower-quality bonds,” he said.
“Credit quality continues to remain strong, despite signs it has peaked,” Howard said.
Gradually slowing state income taxes is of little concern to Howard since many states have built their reserves to record levels and “should be able to withstand a slowdown in revenues,” Howard said, noting that the slowdown in revenues is generally more pronounced for states with a large reliance on income tax revenues.
The strong credit coupled with supply scarcity has helped the market through some of the Treasury volatility this year and most participants expect the supply-demand imbalance to continue.
Roffo said he believesAugust will be another very strong month of reinvestment, while the new-issue calendar continues to remain “depressed”.
The lower-than-expected new issuance in 2023 will also play a larger role in the fourth quarter as investors try to prepare portfolios for 2024 “and realize there are not many bonds available to purchase that fit their structure mandates,” he said.
At least through the third quarter, “munis would seem to have a built-in performance edge thanks to seasonal supply-demand imbalances, which have been producing a heavy supply deficit,” Jeffrey Lipton, head of municipal credit and market strategy and municipal capital markets at Oppenheimer & Co., said last week.
Bill Walsh, president at Hennion & Walsh, Inc., said he believes the second half will carry similar concerns that have made market participants weary for the past 18-plus months, such as recessionary pressures and an extremely hawkish Fed. However, he said positive technical factors should prevail throughout the remainder of the summer and into the fourth quarter.
One trend he expects to continue is individual investors chasing attractively priced, higher-quality credits.
“Given lingering questions regarding Fed hikes, moderating inflation, and current supply-demand dynamics, these types of credits appeal to individual investors seeking tax-free income,” Walsh said. “They are also well-positioned to help withstand economic pressures that may start to appear in the second half of 2023.”
While demand is consistent so far in the second half, he said, retail buyers seem a bit more discerning regarding yield, as absolute yields are 85 basis points higher than at the beginning of the year.
“Mom and pop and high net worth retail have been, and we anticipate that they still will be, active buyers for the near future, given the current market technical and anticipated yield levels,” Walsh said.
Thus far, in 2023, investors have had the advantage of increasing the yield of their bond portfolios “without sacrificing quality,” Walsh said. “This ability will serve as a great advantage if and when the yield curve shifts lower, especially for longer-duration buyers.”
The second half of the year could bring some much-needed stability to the bond markets via investment demand and performance, Lipton said.
“The bond market seems to believe what the Fed has been saying about greater prospects for tighter policy with current Treasury yields now reflecting more realistic levels given historical interest rate correlations,” Lipton said.
“July brought with it technical selling pressure and an unraveling of long positions as prospects for a lower funds rate this year have dissipated,” he added.
Although the Fed may have more to do, “the end-game is in sight” according to Lipton, who does not expect yields to rise appreciably higher through year end.
“While the thought of a rate decrease in the funds rate by year-end is out of the trade for now, sentiment ahead of the September meeting will likely be mixed,” he said. Policymakers will be looking for signs of abating wage pressure and a continued easing in job formation, Lipton said.
Lipton believes that the rally in bonds has some additional room to run.
“Even if we are off-base, the carry trade given the presence of cyclically high absolute yield levels, which is more pronounced for municipal bonds, has contributed heavily to 2023 bond returns,” Lipton said, adding that “reasonable” allocations to fixed income provide portfolio strength with defensive characteristics ahead of the next downturn.
As 2023 began, Lipton had better expectations for performance across most of the fixed income cohorts, but said he didn’t expect “lofty double-digit returns.”
Now, Lipton said the yearend prognosis is strong.
“We continue to believe that munis are poised to outperform Treasuries for the year and finish 2023 with modestly positive returns thanks to constructive technicals and the attractive absolute yield and cash flow opportunities, which strongly argue for duration extensions where feasible,” Lipton said. “We remain confident that retail interest in municipal bonds could become more consistent with greater investment activity should rates stabilize with more subdued volatility.”
The flow environment for munis is more encouraging now than at any other point throughout the first six months of the year, according to Lipton.
While year-to-date outflows have trailed the historic withdrawals of 2022, Lipton said his expectations for more visible inflows during the second half of 2023 should help to support a favorable performance outlook.
Should rate volatility remain in full force during the second half of the year and intermittent sell-offs occur in the bond market — particularly if the Fed moves more aggressively tighter than anticipated — municipals could outperform the weakness, Lipton suggested.