It’s no secret that the first half of 2022 has been one of the toughest periods for fixed income investors dating back to the early 1990s. The combination of rising rates and higher inflation has prompted many investors to turn sour on bonds.
Within fixed income, tax-exempt municipal bonds have been particularly hard hit with one of the fastest and steepest selloffs ever recorded. Yet municipal bonds have historically shown that they can reverse course quickly, unlike other pockets of the bond market. Just recently, we’ve seen more stability in the muni market, with investors starting to dip back in to take advantage of bargains.
There are four main factors supporting munis, which should encourage investors to be more optimistic about these assets:
1. Rising rates: Munis have traditionally outperformed during the Federal Reserve’s rate-hiking cycles, because the yield curve flattens and tends to create better income and total return opportunities, especially for longer-duration bonds.
2. Seasonal tailwinds: Munis generally benefit from some seasonal tailwinds, unlike other parts of the fixed income market. Because most municipal bond investors largely fall in the retail and high-net-worth categories, they tend to pay higher tax bills. In order to pay some of these taxes and harvest tax losses, muni investors tend to sell some of their municipal bond assets. Now that tax season is in the rearview mirror, this added selling pressure should be mitigated for the near-term.
3. Demand outpacing supply: Summer is when many muni bonds mature or pay their investors coupon payments. These proceeds typically are reinvested back into new muni bonds, creating inflows into (and increasing demand) for the asset class. Summertime is also when there’s usually less supply in the market, which helps push bond prices higher.
4. Municipalities in the green: One crucial factor when investing in any fixed income security is assessing the ability of the issuer to pay their debts. Today, many states and municipalities are flush with cash, after a decade-long equity bull market. Concerns about underfunded pensions and overstretched budgets have greatly diminished in recent years, as many states are enjoying budget surpluses and have reined in spending. All of this helps to strengthen the creditworthiness of the municipal bond market, with default expectations at all-time lows. After factoring in the effect of taxes, the taxable-equivalent yield for municipal bonds is particularly attractive.
Catherine Stienstra is head of municipal investments at Columbia ThreadneedleInvestments.