An about-face for the muni market but opportunity remains
An about-face for the muni market but opportunity remains
There has been a marked shift in the municipal market. A year ago, interest rates were about 100 basis points lower, and cash flooded the market week after week. Now, even though fundamentals remain solid, interest rates have climbed, and money is exiting the market. The municipal market reported a -6.2% loss for Q1 2022, the worst quarter in 40 years, a dramatic reversal after a strong performance in 2021. Performance through quarter end is in line with bonds globally as interest rates rise in response to the fastest inflation in decades.
Valuations are leading the performance in the municipal markets. Municipal credit fundamentals are solid at this point in time and pressure is unlikely to build on the vast majority of municipal names in the near term. The market hasn’t seen these valuation levels since the onset of the pandemic. The Schroders Municipal team is actively monitoring new issues and the secondary market, selling expensive bonds for cheaper ones while maintaining credit quality. Where some see volatility, we see tremendous opportunity.
Fundamentals remain solid...
Credit fundamentals recovered quickly from the onset of the pandemic. Numerous sectors across the municipal market received direct and indirect financial support, improving the general credit outlook across many issuers. States across the country are entering budget season, with most operating on a July 1 fiscal start. We expect budget approvals with little fanfare, as revenue growth coupled with federal support have lined the coffers of municipalities across the country. We share a few credit points below highlighting the current strength of state finances.
As shown in Figure 1, combined Rainy Day Funds across the 50 states have surpassed pre-pandemic levels.
- According to the National Conference of State Legislatures,half of states expect fiscal 2022 revenues to exceed originalforecasts; almost 20 expect to meet revenue forecasts and five expect revenues to exceed revenue revisions.
- The Census Bureau released Q4 2021 state and local tax receipts, showing a 13.1% year-over-year increase over Q4 2020. All four tax revenue streams saw growth over the same period, led by corporate income (+53%) and personal income (+19%), followed by sales tax (+14%) and property tax (+3%). Generally speaking, states are more reliant on income and sales taxes, while property taxes are a major source of revenue for local governments.
- The amount of federal support received by state and local governments over the past two years is astonishing. Of the total allocated, approximately $850 billion remains to be spent (Figure 2). Additionally, there is a further $101 billion in direct funds remaining to be distributed to states and local governments (Figure 3).
Technicals are now the driving force
The Federal Reserve (Fed) lifted interest rates for the first time since 2018, raising rates by a quarter percentage point. The FOMC meeting was quite hawkish, with implications for a 25 basis point hike at every meeting for the remainder of the year. Additionally, after the meeting, Chair Jerome Powell made remarks vowing tough action on inflation, stating the Fed will continue to hike rates until inflation comes under control – and those hikes could go from the traditional 25 basis point move to a more aggressive 50 basis points if necessary.
After Chair Powell’s remarks, there was an increase in rate volatility, which continues to remain elevated; the 20-day volatility for the short and long ends of the municipal curve is the highest it has been since June 2020. The municipal-treasury ratio is an industry standard measure for valuations. As shown in Figure 4, 30-year AAA municipals offered 105% of the yield of comparable Treasuries at quarter end; for comparison, the ratio reached 67% in June 2021.
Given the recent volatility, outflows have been reported for the 12th consecutive week (ending March 30). As of quarter end, year-todate fund outflows total $21.9 billion. Figure 5 reflects cumulative fund outflows in the last five years of outflows. As outflows persist, pressure in the new issue and secondary markets intensifies, creating the opportunity for buyers to pick up additional yield.
De minimis becoming a factor
Since the beginning of the year, a higher volume of trades has occurred outside of de minimis. More recently, these trades were mainly concentrated in higher quality names, as shown in Figure 6.
The de minimis tax rule typically applies in a rising interest rate environment, which sees the price of bonds fall and offered at discounts or deep discounts to par.
The de minimis tax rule sets a price threshold to determine whether a discount bond should be taxed as a capital gain or ordinary income. Under the rule, if a municipal bond is purchased and the discount is less than a quarter point per full year between the time of acquisition and maturity, then it is too small to be considered a market discount for tax purposes. Instead, the accretion from the purchase price to the par value should be treated as a capital gain if held for greater than one year.
While de minimis bonds are attractive to corporate buyers because they are basically unimpaired by the de minimis penalty (the max corporate capital gains tax rate (20%) is just 1% below the top ordinary income tax rate (21%)), the same cannot be said for retail investors, who could see a much wider difference in their tax rates.
At the end of the day, investors need to be mindful of this rule; if a bond is in de minimis, you want to be compensated with additional yield to offset the possibility of being taxed if the bond is sold at a future date; ordinary income will be taxed at a higher rate than a capital gain.
Cheapening valuations are an opportunity for new buyers. We continue to find value in the municipal market but are treading carefully as we move through a rising rate environment.
We believe most sectors are well positioned and maintain a stable to positive credit outlook, with many issuers exiting the pandemic crisis with balance sheets and operations supported by almost two years of stimulus support and little need for cash borrowing. Upgrades have been outpacing downgrades by a wide margin, but this ratio should start to normalize in the upcoming year. To note, issuers with troubled balance sheets prior to the pandemic have benefited from additional support from the stimulus but we continue to monitor the landscape carefully.
While current fundamentals are strong, concerns about inflation, the speed of the Fed’s rate hikes, and looming fears of recession could be headwinds for a stronger municipal recovery. At this point, the market is being driven by valuations rather than credit quality. We continue to recommend selectivity in names, with careful consideration needed for riskier credit names at current valuations. Investors are facing uncertainty as muni-Treasury ratios fluctuate. We remain cautious but we believe at these ratios investors would be smart to dip in their toes.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.