Outflows Can Create Potential Opportunities in Municipal Marketplace

Higher yields, wider credit spreads, and other common market reference metrics suggest relative valuations for muni bonds have become attractive.

In the long-term cycle of municipal bond fund flows, extended periods of withdrawals can often help improve valuations across the marketplace, creating more appealing entry points to invest. Munis have experienced a long spell of outflows to start 2022, and many frequently cited reference metrics suggest valuations are now unusually attractive, not only compared with levels seen a few months ago but also on a longer-term basis.

While the turmoil that has played out across financial markets this year hasn’t spared municipal bonds, we believe it has created interesting opportunities. The cumulative effect has been a substantial move higher in tax-exempt yields, making the tax benefit of investing in munis much more compelling. For context, five-year A rated muni yields recently rose above 2.7%, according to Thomson Reuters, within the top percentile of yield levels seen over the past decade. It’s also the highest level since late 2018, when the Federal Reserve was already deep into a rate-hiking cycle and the 10-year U.S. Treasury yield was near 3.25%.

Relative valuations for investment grade munis, which appeared rich to begin this year, have cheapened and are now the most attractive we have seen since late 2020. As bond yields have moved higher, muni-to-U.S. Treasury yield ratios have also risen. Investment grade municipal bond spreads measuring the after-tax pickup versus comparable corporate bonds have widened as well (see Figure 1).

Figure 1: This graph tracks the spread of AA municipal bonds versus after-tax corporate bonds from 2006 to 2022.

Lower down the credit spectrum, high yield munis also offer improved yields relative to high yield corporate bonds after accounting for taxes.

Shifting market structure

Muni outflow cycles have created an expanded set of opportunities for active fund managers in recent years, in part due to changes in market structure.

Over the past decade, the stockpile of muni bonds held by banks to help intermediate risk is down about 70%, according to Federal Reserve data. Banks and insurance companies are also less likely to become buyers during times of market stress, after corporate tax rates declined in 2018 to 21% from 35%, making tax-exempt munis less attractive for institutional investors.

Meanwhile, the potential needs for daily liquidity have grown significantly, with daily liquid muni vehicle assets under management (AUM) more than doubling since 2012 to over $1 trillion today, according to the Federal Reserve. As a consequence, volatility has become more pronounced during market outflow cycles.

Amid this year’s market volatility, muni bonds have seen increased differentiation and dispersion on the individual security level. In the secondary market, where existing bonds are traded, outflows have resulted in elevated bids wanted, meaning many bonds trying to be sold all at once. Securities in less-liquid sectors, or with features that make them less liquid, trade at wider bid/ask spreads as a result, creating improved investment opportunities.

In the primary market, where new bonds are issued, fewer bidders have been willing or able to participate due to outflows. Thus, buyers with dry powder have increased leverage to influence deal terms and capture more attractive levels of yield. In some cases, the lack of liquidity in the market has been so acute that deals have been withdrawn by issuers.

Fundamental and technical strength

The current outflow cycle is now almost as large as the one seen in 2020, at the advent of the pandemic, and has contributed to an outsized 175-basis-point (bp) rise in yields. Previous outflow cycles (see Figure 2) have often signaled buying opportunities, preceding periods of spread tightening.

Figure 2: This chart shows changes in monthly municipal fund net flows from 2010 to 2022, along with investment grade muni yield-to-worst and high yield muni yield-to-worst. The retail-heavy market has seen large outflows during periods of market stress, such as the COVID-19 crisis.

Even as fund flows and returns have been challenged this year, municipal credit fundamentals continue to improve. Issuers are benefiting from increased post-pandemic economic activity, unspent federal stimulus funds, and strong tax collections bolstered by residential real estate valuations, helping municipal credit rating upgrades outpace downgrades. As an example of this strength, Moody’s in April upgraded its bond rating for Illinois – the lowest-rated U.S. state – for the second time in the past year, the state’s first upgrades in two decades.

Technical factors should also help support the tax-exempt muni market, with expectations for net negative bond supply in 2022, meaning new issuance will lag behind the pace of maturing debt.

With the Fed poised to raise interest rates several more times in 2022, it’s notable that munis have historically outperformed Treasuries and corporate bonds during the past two Fed rate-hiking cycles. Tax-exempt munis have also shown resilience relative to other fixed income assets when the 10-year Treasury yield has risen significantly (for more on muni performance during periods of rising rates, see “Munis in Focus: 2022 Municipal Market Update.”)

Municipal credit quality tends not to be materially affected by rising rates because most issuance is fixed-rate, long-term debt. Corporations, by contrast, are more likely to be hurt by rising short-term rates because they issue more short-term debt.

In addition, the 10-year cumulative average default rate for municipals is lower than that of corporate bonds across all equivalent credit ratings, according to Moody’s. This is most pronounced in speculative-grade debt, where the default rate for municipals has averaged about 6% compared with about 30% for corporates.

The pronounced market movements of early 2022 are creating more attractive entry points for investors in terms of potentially higher after-tax income. With higher yields and wider credit spreads compared with the start of the year, munis appear particularly attractive for those seeking a tax-efficient way to invest.

Visit Municipal Bonds at PIMCO, our central hub for muni content and investments.

David Hammer is a managing director in the Newport Beach office and head of municipal bond portfolio management.

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