As investors continue to contemplate the effects of volatility and tightening monetary policy across asset classes, municipal bonds could be buttressed by traits that have helped them outperform during past periods of rising interest rates.

Financial markets have endured a tumultuous start to 2022, with volatility likely to remain a threat in the months ahead amid heightened geopolitical uncertainty and persistently elevated inflation. That aligns with PIMCO’s Cyclical Outlook, “Investing in a Fast-Moving Cycle,” which examines how the current economic cycle has been unusually rapid. Markets appear to be transitioning toward late-cycle dynamics as the Federal Reserve begins raising its policy rate to tame inflation.

In recent history, tax-exempt munis have exhibited resilience relative to other fixed income assets both when the Fed has raised rates and when the 10-year Treasury yield has risen significantly. Munis have also demonstrated a low correlation with equities and other risk assets, which may offer diversification attributes to portfolios.

Municipal credit fundamentals are expected to retain recent positive momentum, as state and local government coffers have recovered from pandemic pressures with the help of federal aid. There are also technical tailwinds supporting the muni market, such as expectations that the pace of maturing muni bonds will outstrip new issuance this year.

Municipal bond funds have been mired in a period of outflows amid the market volatility that has defined the early months of 2022. That dislocation is creating opportunities for active management and has provided a more attractive entry point for investors in terms of potentially higher after-tax yields.

Recent declines improve technical backdrop

Like stocks, bonds, and other assets, munis have been hit hard by volatility to begin the year, which came after the muni market entered 2022 with exceptionally rich initial conditions that became the primary drivers of weakness. Tax-exempt munis endured the worst January performance since 1981, with the investment grade muni index declining 2.74%, and the high yield index falling 2.80%, according to Bloomberg data.^Footnote[i] Investors pulled $12.4 billion from municipal funds in the first two months of the year, according to Lipper data.

High-grade tax-exempt munis now appear to be back to levels suggesting long term fair value, as measured by the after-tax pickup versus comparable corporate bonds and by muni-to-U.S. Treasury yield ratios. These ratios suggest the muni market has cheapened, providing a more attractive entry point to invest.

Limited supply will help support the tax-exempt muni market through the balance of 2022. Municipal issuers will continue to rely on taxable refinancings, as opposed to tax-exempt advance refundings, due to tax-law changes in 2017. While the taxable muni market should continue to grow, 2022 will likely be another net negative supply year for tax-exempt municipal bonds.

Sound foundation for credit

Continuing a trend seen for much of 2021, municipal credit fundamentals are expected to remain strong, with federal pandemic relief helping to swing many state and local budgets to surpluses from deficits. There are two major themes that signal supportive 2022 credit trends:

1) Continued strong tax collections. Year-to-date revenues are higher relative to pre-pandemic 2019 levels, with state income tax revenues up 12.7% and sales tax up 9.3%, according to Urban Institute data as of 10 March 2022. Local governments should additionally benefit from generally strong residential real estate valuations in 2020 and 2021 – which saw record-setting growth in many metropolitan areas – driving stable-to-improving 2022 property-tax collections.

2) Many state and local governments retain dry powder from past rounds of federal relief funding that can be appropriated in 2022. The U.S. Treasury only recently released final guidance on American Rescue Plan spending, and many municipalities had waited on this guidance before finalizing intended expenditures for their portions of the plan’s $350 billion of Coronavirus State and Local Fiscal Recovery Funds. We expect federal funds to continue to play a stabilizing role through 2022 across a wide range of municipal sectors, including higher education, airports, and not-for-profit health care.

High credit quality and low correlations to other markets have historically helped make munis a safe haven asset class later in economic cycles. Muni default rates remain well below those of their corporate counterparts. Lower correlations to riskier parts of financial markets, such as high yield corporates and equities, offer attractive diversification benefits.

Strong track record when rates are rising

On a tax-adjusted basis, investment grade munis have outperformed Treasuries by 344 basis points (bps) annualized during the past two Fed rate-hiking cycles, while outperforming U.S. investment grade corporate bonds by 253 bps. High yield municipals have achieved even greater levels of outperformance compared with taxable bonds.

The simple math behind tax-exempt income tends to be the primary driver of muni outperformance during periods of rising rates. As absolute yield levels rise, the value of the tax exemption embedded in most munis becomes increasingly valuable.

For example, if a comparable taxable bond yields 1%, an equivalent muni might yield about 0.70%, making the marginal investor with an assumed 30% tax rate equally well-off owning either bond. If the yield on the taxable bond moves up to 2%, the new equilibrium will be at a muni yield of 1.40%. The smaller increase in tax-exempt yields (+70bps vs. +100bps) means smaller price losses for investors holding munis relative to losses on taxable bonds.

Another factor that has helped support muni valuations during periods of rising rates is credit spread tightening. Treasury rates tend to rise during periods of strong economic performance, and the same macroeconomic forces tend to support muni credit fundamentals and thus compress credit spreads. Historically, this dynamic has led to especially strong performance for high yield munis, which tend to be more sensitive to credit spread fluctuations than their investment grade counterparts.

In addition, higher rates can provide a disincentive to municipalities to refinance outstanding debt, helping to suppress municipal bond supply as rates move higher.

Labor, ESG loom as headwinds

Although we expect fundamentals to remain robust, there are several risks we are watching closely. Municipalities, like their corporate counterparts, are likely to experience ongoing labor-market pressures, which may drive increased spending to fill critical open positions and could result in generous long-term contracts aimed at retaining employees.

Additionally, we expect environmental, social, and governance (ESG) factors to become increasingly dominant for credit analysis. Environmental concerns are likely to drive a growing portion of borrowing needs.

Municipalities are putting more attention into climate resilience and adaptation efforts as the effects of climate change force hard capital choices on infrastructure decisions. The federal infrastructure bill’s $47 billion for climate resiliency projects will likely spur more local borrowing for such projects in the coming year and beyond.

Pockets of potential opportunity in Puerto Rico, market illiquidity

One particular area of focus for the muni market in 2022 is Puerto Rico, which is set to emerge from a six-year territorial bankruptcy. A planned debt exchange will bring new Puerto Rico bonds to market.

Before the bankruptcy, the commonwealth’s bonds were long prized by muni investors because the interest is exempt from federal, state, and local taxes for holders throughout the U.S, and because yields have traditionally been higher than most U.S. munis due to elevated perceived risk.

Restructured muni debt typically outperforms the broader muni market as issuers emerge from bankruptcy with higher debt-servicing capacity and the debt re-enters the municipal high yield index. Municipal high yield funds tracking the index may reposition their funds into Puerto Rico bonds, and trading desks may begin to trade the commonwealth’s debt.

Opportunities arising from market outflow cycles have also increased in recent years. Banks hold smaller inventories of municipal bonds to help intermediate risk than they used to, down about 70% over the past decade, according to Federal Reserve data. During the same time period, the potential needs for daily liquidity have grown substantially. Daily liquid muni vehicle assets under management (AUM) have surged since 2012 from $400 billion to over $1 trillion.

Additionally, with corporate tax rates down to 21% from 35%, tax-exempt municipals are less attractive to U.S. banks and insurance companies. This investor cohort is less likely to step into the market and become a buyer during times of moderate stress.

The combined effect is more frequent bouts of volatility during market outflow cycles. For investors with the flexibility to step in and provide liquidity during these cycles, the opportunity set is likely growing in 2022.

With volatility revisiting financial markets this year, investors may want to reevaluate their allocations to tax-exempt municipals as a possible source of diversification in a rising-rate environment. Not only have tax-exempt munis outperformed many taxable fixed-income sectors during past Fed rate-hiking cycles, but credit fundamentals are strong and market yields have become more attractive on both an absolute basis and when compared with U.S. Treasuries. Active managers such as PIMCO may provide further benefits by taking advantage of market opportunities and mispricings when they arise.

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