Last year’s sharp move higher in yields and record fund outflows reset the baseline for the municipal bond market, establishing strong initial conditions entering 2023. Already we see signs of a rebound, and munis appear positioned to continue providing attractive, tax-advantaged income and potential portfolio diversification benefits, particularly as the effects of tighter monetary policy play out across the U.S. economy and financial markets.

PIMCO’s base case calls for economic stagnation with elevated recession risks this year as the U.S. Federal Reserve (Fed) works to quell inflation, providing a supportive backdrop for bonds (for more, see our latest Cyclical Outlook essay, “Strained Markets, Strong Bonds”). Historically, munis have tended to fare well in recessionary environments. Munis have also typically exhibited a low correlation with equities and other risk assets that could be more challenged in an economic downturn.

Revenue and credit quality have strengthened in recent years for state and local muni issuers, with tax coffers bolstered by home price appreciation and federal pandemic aid. We expect this improvement to help offset any headwinds for state and local economies.

We currently find better relative value in longer-dated debt compared with other parts of the muni yield curve. Certain high yield opportunities are also becoming more attractive.

Improved market dynamics

In 2022, munis had their worst year since 1981, posting a −8.5% total return, according to the Bloomberg Municipal Bond Index, while still significantly outperforming many other major asset classes. That outcome aligned with our outlook a year ago, when we highlighted muni bonds’ track record of outperformance during prior periods of rising interest rates (for more, see our “Munis in Focus: 2022 Municipal Market Update”).

Muni yields were near all-time lows at the end of 2021, with the 10-year AAA yield at 1.03%, according to Refinitiv, after a record $102 billion of fund inflows that year had stretched valuations. Persistent inflation and a hawkish Fed changed the backdrop in 2022, as yields surged to 2.63% by year-end while muni funds experienced a record $122 billion of outflows.

Amid the volatility, there was a flurry of tax loss harvesting in late 2022 as investors looked to optimize their tax obligations after a record sell-off and to capitalize on higher reinvestment rates. Credit spreads widened, providing more compelling entry points for lower-credit-quality assets as well.

Historically, municipal fund outflow cycles have often been followed by periods of equally vigorous inflows and price rebounds. Munis have shown signs of that dynamic playing out in early 2023.

Sound credit foundation and diminished supply

The muni market emerged from last year’s turmoil not only with more attractive yields but also with strong fundamentals and favorable technical factors.

Issuers have benefited from increased post-pandemic economic activity, unspent federal stimulus funds, and robust tax collections. As a result, many issuers carry historically large cash reserves that could soften the immediate impact of a possible recession. Rating companies have taken notice, with a municipal upgrade-to-downgrade ratio of 3.5-to-1 through the first three quarters of 2022, according to Moody’s. New Jersey and Illinois are examples of U.S. states that have received credit rating upgrades in the past year.

Municipal bond issuance was just $396.7 billion in 2022, according to Refinitiv Lipper and JPMorgan data, well below most industry forecasts from the beginning of the year and a 20% decrease from the $498.6 billion in 2021. That decline in new supply has supported pricing for existing bonds.

Taxable munis may have the strongest tailwind from shrinking supply. Issuance volume in that sector was hit particularly hard as rates rose in 2022, falling more than 50% from 2021. This supply is likely to decline further amid diminished opportunities for refinancing in the taxable market.

Pockets of opportunity

We see a variety of interesting opportunities across the muni market today:

Longer-maturity munis have lagged behind the recent recovery in shorter-dated bonds. Unlike the U.S. Treasury yield curve, the tax-exempt municipal curve remains upward-sloping (see Figure 1), with 30-year muni yields 140 basis points higher than 5-year yields. In addition to potential return from spread compression, investors could benefit from price appreciation as longer-dated bonds “roll down” the relatively steep tax-exempt curve.

High yield munis historically have a lower default rate than high yield corporate bonds (see Figure 2). After spreads widened last year, select high yield opportunities look more appealing, including some of the sectors mentioned below.

Puerto Rico bonds boast an improved credit profile and new security features after a restructuring that reduced the commonwealth’s debt outstanding by about 45%. Hurricane disaster relief and COVID-related federal stimulus have buoyed the island’s finances, with aid collectively expected to exceed $130 billion, or more than 135% of Puerto Rico’s GDP, according to PIMCO estimates. This will likely drive consumption and sales tax collections for years. We particularly like bonds issued by the Puerto Rico Sales Tax Financing Corporation (known by the Spanish acronym COFINA), which are secured by sales tax collections.

Prepaid natural gas bonds allow municipal utilities to secure natural gas supplies through 20–30 year contracts at a discount to the current spot rate. This sector cheapened through 2022, with the bonds recently yielding more than 5%, or about 90% of their taxable corporate equivalents (versus a long-term average of 60%–70%), according to Bloomberg. We view these bonds as a way to increase yield without sacrificing credit quality. Additionally, with a relatively short three- to five-year duration profile, these securities have comparatively low interest rate risk as well as the potential for price appreciation.

Workforce housing bonds have benefited from rental inflation, with rent increases passed through to bondholders. PIMCO retains a supportive view of housing based on supply/demand dynamics (for more, see our January Viewpoint, “Staying in Place – The Post‑Pandemic Housing Market”). Although their prices fell amid last year’s sell-off, workforce housing bonds amortize at par, so the weighted average life decreases as they receive additional cash flow. So while these bonds may offer a yield-to-maturity of 5.5%, according to Bloomberg, the amortization payments – along with discounted trading prices – mean the bonds are trading at an actual realized yield profile closer to 8%–9%.

Tobacco settlement bonds similarly present an attractive inflation-hedging opportunity. These bonds are based on a 1998 settlement agreement between U.S. states and cigarette manufacturers – to compensate for tobacco-related health costs – that entitles states to a fixed percentage of settlement proceeds in perpetuity, adjusted for tobacco consumption and inflation. While consumption was down about 6% last year, the inflation adjustment was about 7%, according to data from the National Association of Attorneys General. The inflation adjustment therefore offset the consumption decline and contributed to better-than-anticipated cash flows for these bonds. Tobacco settlement bonds are typically some of the more liquid securities in the market, and PIMCO’s structured credit expertise has helped us identify the more attractive opportunities in the sector.

Potential headwinds

With some sort of U.S. recession widely forecasted for this year, many state and local governments are preparing for a growth slowdown and have already lowered their budgeted revenue assumptions accordingly. Although municipal credit largely enters this period from a position of strength, there are a few areas where we see potential challenges:

• The lingering work-from-home impact on urban areas poses challenges for large cities that have yet to reach a full economic recovery to pre-COVID levels. Bonds backed by mass transit revenue, commercial real estate property taxes, and certain city general obligation bonds are at risk of underperforming as federal stimulus wears off in the coming years.
• Senior living facilities are likely to remain under pressure. Occupancy declines resulting from the pandemic, coupled with significant skilled nursing wage inflation, are squeezing profit margins for operators. Compounding the problem, some regional markets were overbuilt in the years leading up to COVID. In many cases, we expect debt restructuring will be the only viable solution. More than 10% of senior living bonds outstanding are currently in default.
• The nonprofit healthcare sector held up well during the pandemic due to federal support but is now facing headwinds such as labor shortages, inflationary pressures, and weaker investment performance. May nonprofit hospitals have reported declining financial metrics for 2022 and have continued to defer capital spending. However, credit stress is not equivalent to credit distress. Careful security selection can identify opportunities arising from dislocations in fundamental fair value, particularly in dominant providers with integrated operations. Essential status, strong labor relations, and revenue diversification are also factors that can provide value in lower-quality issuers.

Outlook remains attractive

Municipal bonds appear to have entered a much more attractive period in the wake of last year’s volatility (for more, see our View from the Trade Floor video with Group CIO Dan Ivascyn, “5 Compelling Reasons to Consider an Investment in Munis Today”). Higher yields, high credit quality, and low correlations to other markets have historically benefited munis later in economic cycles, when riskier assets often encounter more challenges. History suggests munis could potentially outperform taxable fixed income in a scenario in which rates rise further than expected.

Although a slowing U.S. economy may present challenges, many municipalities are buffered by strong balance sheets, and we do not expect a deviation from the lower historical default rate munis have exhibited relative to corporate bonds.

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