Reviewing The Past 12 Months: Concerns Over A Potential Recession Shifted Market Sentiment Negative
Aa
Share
While 2022 was a challenging year for the muni-bond market, 2023 is setting up for more positive momentum, according to Franklin Templeton Fixed Income Municipal Bond Director Ben Barber. Read the team’s views on the year ahead.
2022: A persistently volatile year
Reviewing the past 12 months, municipal bond (muni) investors will be hard pressed to find a more persistently volatile market time since the global financial crisis of 2008. At the beginning of the year, the US Federal Reserve (Fed) maintained its fed funds rate at the zero-lower-bound, and concerns over rising inflation were muted as many thought that these forces were “transitory.” But as the year progressed and inflation marched higher, the Fed entered a period of rapid rate hikes at a pace and magnitude not seen since the 1980s. The fed funds rate moved to an economically restrictive 3.75%–4.00% range. Consequently, US Treasury (UST) yields moved much higher, particularly on the front end of the yield curve.
Increased market volatility negatively impacted most fixed income sectors as concerns over a potential recession shifted market sentiment negative. Munis were not exempt, as the sector saw large continuous outflows of funds throughout much of the year, driving down valuations. This, coupled with rising UST yields, led to poor absolute performance for munis—the Bloomberg Municipal Bond Index has declined 9.32%1 year-to-date, and yields rose from 1.12% to 3.65%.2 The selloff was broad-based over most sectors and rating classifications. Despite the negative technical tone, there have been several short periods of strong positive performance, which indicates the market’s resilience and investors’ appetite to return to the asset class. These factors speak to a technically driven selloff, rather than one driven by poor credit fundamentals.
Fundamentals remained strong throughout 2022, and we have observed many more rating upgrades than downgrades. Many muni issuers have been operating at surpluses for the better part of the past 12 months and have been able to increase their contributions to “rainy-day” funds. New-issue supply has been lower for most of the year in both the tax-exempt market and taxable muni market.
At the beginning of 2022, muni valuations were considered “expensive;” however, they cheapened aggressively as fund outflows increased by mid-April. This trend carried on for most of the year. Only in the latter part of November did we start to see shorter-maturity bonds become expensive relative to historical averages as investors moved out of their cash holdings into less interest-rate sensitive positions, while still capturing a strong yield pickup.
Technicals Driving Selloff
Exhibit 1: Long-Term Mutual Fund Net New Cash Flow in Millions, US Dollars
As of November 30, 2022
Source: Investment Company Institute. Estimated Long-Term Mutual Fund Net Cash Flow “Release: Estimated Long-Term Mutual Fund Flows | Investment Company Institute (ici.org).
Despite the poor performance relative to previous years, the municipal bond sector remains in a fundamentally stable position with valuations cheaper than those of 2021 where the sector saw record inflows.
Muni momentum looking more positive in 2023
Looking forward into 2023, there are a few key themes that we believe could provide strong momentum for munis. First, the technical environment may be shifting more positive as tax-loss harvesting and fund redemptions slow. As the Fed cuts back its pace of interest rate hikes, this could provide a path for a more stable yield environment, which would bolster investor confidence in the sector. Munis can be valuable for investors looking to find an attractive yield, especially considering the after-tax equivalent options available.
Fundamentals remain strong as surpluses have accumulated over the past several years, and prudent fiscal budgeting will continue to provide a ballast to balance sheets. With the threat of a recession still an overhang on the market, we are paying particular attention to several sectors as we progress through 2023. We feel security selection will become even more critical in 2023, with deep credit research proving vital to investment returns. We believe opportunities will continue to present themselves up and down the credit quality spectrum in 2023.
Moving into 2023, valuations will need to be closely watched. The shorter end of the maturity curve has been extremely active in late 2022, and its yields have moved lower more aggressively than longer-maturity bonds. Investors seem to be nervous about the Fed’s rate-hiking cycle and may continue to favor a shorter-duration positioning. That being said, the longer-maturity end of the muni yield curve looks attractive to us on a historical basis. Additionally, the potential carry from higher muni yields further solidifies the opportunity for investors to take advantage of better valuations available on the longer end of the curve.
Endnotes
- Source: Bloomberg as of November 25, 2022.
- Source: Bloomberg as of November 25, 2022.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the portfolio’s value may decline. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.
