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By EV Forward

New York & Boston - Faced with renewed geopolitical conflict and resurgent inflation, investors today are trying to determine the appropriate way to respond to rare challenges. For municipal investors, the market is in the midst of a historic sell-off. Let's look more closely at how muni bonds have fared during previous turbulent periods, and consider why their strong credit fundamentals and tax advantages might make this a buying opportunity.

Year to date through April 25, AAA benchmark yields are up 165 basis points (bps) in the 10-year maturity and along most of the yield curve. Over the past decade, there have been three instances when yields have risen that far that fast: during the 2013 taper tantrum, following the 2016 presidential election and during the pandemic-induced recession of 2020.

We can use a round 100-bps move in yields as a threshold for a trigger point. In all three historical instances, six months from the day that the 10-year AAA benchmark first recorded a 90-day, 100-bps rise, the market had rebounded and yields were notably lower. For comparison, the six-month rebound was 39 bps in 2013, 50 bps in 2016 and 195 bps in 2020.

Historical rises in the 10-year AAA municipal yield curve

AAA10yrMuniYld0428

Source: Thomson Reuters Municipal Market Data as of 4/25/2022. For illustrative purposes only. Not a recommendation to buy or sell any security.

Based on the experience of the past decade, this new yield hike could potentially be an attractive entry point. With high equity valuations, a flattening Treasury curve and aggressive posturing from the Federal Reserve, we can envision an outcome where municipal bond market performance follows that historical pattern.

Muni bond yields and inflation

We could also paint a less optimistic picture, however. A key difference between today's yield hike and the three before is the presence and persistence of elevated inflation, which has been quite rare. Using quarterly consumer price index (CPI) data as a barometer and looking back half a century to 1972, the average year-on-year change has been 3.9%.

We count four instances where the annualized change in CPI reached 5% and then returned to the average of 3.9%. Markets saw an extended inflationary period starting in 1973, a shorter burst of inflation in 1989, a brief reoccurrence in 2008 and the current instance that began in the first quarter. Given investors' limited experience with inflation, using past experience as a guide may not be appropriate.

Observers frequently draw a comparison between today and 1973, when an oil shock hit just as the global economy was experiencing significant and sustained rises in inflation. But that parallel may not hold up to scrutiny: today's oil price increase of 45% after the invasion of Ukraine pales in comparison to the OPEC oil embargo's spike of 379%. Besides, the nature of the economy and our understanding of economic policy has advanced since then.

Investors can be more confident now that the Fed has the correct and necessary tools to tame inflation, and will act decisively through a combination of quantitative tightening and interest rate increases to contain today's elevated rate of annual CPI inflation. We expect inflation to be lower by the end of the year — possibly even below the long-term average of 3.9%. The rapid flattening of the Treasury yield curve could be indicating that market participants also believe inflationary expectations may not settle at the current annualized rate.

Until we see evidence of a clear reversal of the current CPI trend, we expect municipal yields to have an upward bias. For investors who have been rattled by the ferocity of the current move, one option is to stay the course. Over time, reinvestment at higher yields should reduce the impact of recent price action on their portfolios, especially given the strength of muni credit fundamentals.

Here are four reasons why we think muni credit fundamentals remain strong:

  • Significant federal support. Three federal stimulus packages in 2020 and 2021 —$2.2 trillion CARES Act, $900 billion COVID Relief Bill and $1.9 trillion American Rescue Plan — injected almost $1 trillion of credit support into the municipal market. This aid helped stabilize municipal credit during the pandemic and set most issuers up for solid growth in 2021 and into 2022.

  • Record state revenues and liquidity. For the calendar year ended December 2021, state tax receipts increased by 19% from 2020. Calendar year 2021 tax receipts are up on average 18.6% versus 2020 and 16.6% versus 2019. The record revenues drove the largest state and local budget surpluses since 1941 — 1.2% of GDP — and a new high for state rainy day funds of $113 billion.

  • Credit upgrades outpacing downgrades. Upgrades have outpaced downgrades as overall credit quality has been bolstered by significant federal support, an improving vaccination rate and strong GDP growth. Last year was very positive from a credit ratings perspective, as the credit rating agency, Moody's, upgrade to downgrade ratio was 2.7 to 1, while S&P upgraded 1.85 credits for every downgrade.

  • Declining defaults. Significant stimulus funding and an improving economy pushed unique defaults down to 65 in 2021 from 86 in 2020. Defaults continued to decline in the first quarter of 2022, with 16 unique defaults, down from 23 during the same period last year.

Muni tax advantages and crossover trades

For investors in the highest federal tax bracket, tax-free municipal bonds have generally offered the highest after-tax returns compared with other high-quality investments, such as U.S. Treasurys. While this has been largely true through various U.S. tax regimes, it may not always be the case.

We interpret the relationship between AAA-rated munis and Treasurys as a ratio of tax-exempt yields to Treasury yields. When the muni-to-Treasury ratio is low, an investor can sell out of relatively overvalued tax-exempt bonds and purchase a U.S. Treasury or high-quality taxable municipal bond of the same maturity. When market conditions change and the ratio reverts to the mean, the investor can reverse the trade. These are often called crossover trades. When a professional active manager executes them properly, these trades have proven beneficial to certain investors.

It's important to consider the tax consequences of selling a municipal bond to buy a taxable position. Significant gains may erode the value of the crossover trade, when the realized gain on the municipal bond sold may outweigh any alpha that the trade may generate down the road. This is especially true in the case where municipal bond positions are trading at short-term gains.

We should also factor in credit ratings when comparing muni yields versus U.S. Treasury yields. As investors move down the credit spectrum, the higher yield on bonds rated below AAA will typically result in cheaper ratios, which justifies staying in the muni asset class. Furthermore, the presence of embedded calls in municipal bonds with maturities longer than 10 years has limited this crossover to maturities shorter than 10 years.

Bottom line: Any acceleration in the pace of outflows that results in a fresh sell-off from current yields could represent an attractive entry point. Absent that opportunity, rising yields could be headwinds, but we think investors looking for tax-free income can put cash to work in municipals today. We would look for defensive strategies such as laddering,1 tax-loss harvesting2 and using active managers with demonstrable track records of outperformance in a rising rate environment.

  1. Laddered portfolios have equal exposure to each maturity year that investors select. Bonds either mature or are sold when their maturity falls below the shortest maturity in the range. Proceeds are then reinvested at the longest maturity in the range. Since ladder reinvestment occurs at the longest maturity, it will be at the highest-yielding maturity in a positively sloped yield curve.

  2. Tax-loss harvesting is a strategy for managing taxes in an investment portfolio. Selling a security that is trading at a loss creates a realized tax loss, which can be used to offset a capital gain realized in the same year.

Evan Rourke, CFA
Director, Portfolio Management — Parametric

Nisha Patel, CFA
Managing Director — Parametric

Bill Delahunty, CFA
Municipal Portfolio Manager

Cindy Clemson
Co-Director of Municipal Investments