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Text on screen: David Hammer, Head of Municipal Bond Portfolio Management
Hammer: 2022 has been a challenging year for muni investors. Supply side disruptions and surging commodity prices have caused inflation to remain stubbornly high. The Federal Reserve is raising rates faster than initially expected, and the US muni market is in the midst of one of the largest outflow cycles ever.
Sharp outflow cycles have historically signaled buying opportunities, as valuations need to cheapen to draw in new buyers. We see an opportunity in munis today for US taxpayers for a number of reasons.
First - valuations are historically attractive versus taxable fixed income. 10 year munis have cheapened from trading at about 65% of US Treasuries at the beginning of the year to as much as 100%, before settling in recently at about 85%
Tax Exempt munis have also cheapened relative to taxable corporate bonds.
And absolute yields have risen significantly as well. 5yr Munis at 2.25 – 2.50%, tax fee, are near the highs of the last decade.
Secondly, credit fundamentals are largely improving across state and local governments, as we discussed in our most recent Munis in Focus outlook.
For example, the state of California has a record budget surplus of $98 billion. And the State of Illinois was upgraded recently for the first time in 25 years.
At the local level, property taxes make up a large percentage of revenues collected by local governments. Home prices have appreciated by 10-15% in many areas over the last year, and this will be a tailwind for local government credit in the years ahead.
Lastly, as the pace of monetary policy tightening has increased, recession probabilities are rising – we are looking at our portfolios increasingly through a late-cycle lens. And we tend to favor tax exempt munis late cycle, for a few different reasons.
Number one, they have lower default rates than investment grade or high yield corporate bonds, lower correlations to equities, and tax exempt munis have historically outperformed taxable fixed income during fed hiking cycles.
As an active manager here at PIMCO, we are seeing a wide variety of attractive opportunities in the muni market lately.
We’ve seen opportunities in the utility sector to purchase investment grade tax exempt bonds that are trading at higher yields than where taxable debt backed by the same issuer is trading. Prepay gas bonds backed by US financial institutions are trading at tax free yield of 3.50-4% in 5-10yrs, that’s a taxable equivalent yield of about 6%, which is higher than where parity taxable risk trades.
We are focused on smaller local government issuers with improving credit fundamentals that offer a yield pick-up versus larger, more well-known issues.
And then lastly we are finding opportunities in single name credits that actually benefit from inflation, such as multifamily housing projects that tap the muni market to finance affordable or workforce housing.
In short, with higher yields, cheaper valuations, and wider credit spreads compared with the start of the year, muni bonds offer a particularly attractive opportunity today for those seeking a tax-efficient way to invest late cycle, without sacrificing on credit quality.
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Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax.
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Taxable-equivalents yields assume a flat tax rate of 40.8% for a combination of federal, state, and local tax rates. This analysis does not take into account all tax considerations.
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