Boston - Last year was extremely challenging for municipal bonds, with the investment grade (IG) index1 returning -8.5% in 2022, while the high yield (HY) muni market2 fared even worse at -13.1%. With the stage set for a bounce back this year, we view the beginning of 2023 as a good entry point into the HY muni market. Let's consider the reasons why.
Muni credit in good shape
In our view, 460 basis points (bps) of underperformance in HY relative to IG was not a credit event; rather, it was mainly due to differences in duration amid a sell-off in rates. Two-thirds of the HY muni index have maturities greater than 20 years, compared to one-third of the IG muni index. Higher duration means greater sensitivity to changes in interest rates. With duration at 11 years for HY, versus 6 years for IG, is it any wonder that rate shifts hit HY munis harder than IG munis?
Even though muni credit is in good shape, we saw significant spread widening in 2022, which accelerated in the second half due to the fund outflow cycle. Of $121 billion in outflows from muni funds for the year, $20 billion was from HY funds — representing 15% of total HY assets.
This resulted in forced selling of bonds and drove HY spreads relative to IG wider in the second half of 2022. HY spreads over IG started the year at 158 bps — more than one standard deviation tighter than the 5-year average — then ended the year at 285 bps — close to one standard deviation wider than the 5-year average. That was a total of 127 bps of widening, or an 80% increase in spreads throughout the year.
Meanwhile, spreads in the BBB segment of the HY muni market were 38 bps on January 1, 2022, widening to 144 bps on December 21, 2022, with 106 bps of widening representing a 278% increase!
Bounce back expected for BBB and HY munis
Historical experience suggests that we could see a bright side to 2022's underperformance by HY munis. The HY index almost never lags the IG index in consecutive years, with the only exceptions over the past 20 years coming in 1999 and 2000 (though returns were still positive for HY and BBB-rated munis in 2000), as well as in 2007 and 2008.
We see one caveat with extrapolating the historical experience: Most economists are predicting a recession in 2023. If indeed there is a recession this year, it may be one of the most widely anticipated recessions of all time. According to the Wall Street Journal, more than two-thirds of economists at financial institutions that do business with the Federal Reserve are betting that the economy will be in a recession in 2023.
More often than not, the consensus is just plain wrong. Recall that at beginning of 2022, market expectations were for the Fed to hike a total of 75 bps. By year-end, however, policymakers had raised the fed funds rate by an extraordinary 425 bps!
With such an uncertain economic environment, we believe that opportunities exist in the BBB-rated segment and higher-rated BB segment of the HY muni market.
HY muni outperformance over time
As our last exhibit for the potential attractiveness of HY munis, we present trailing annualized returns over 3, 5, 10 and 15 years through 2022. Over all horizons, the HY index has outperformed the broad muni index.
In our view, the 3-year result is especially compelling, including both 460 bps of underperformance from last year as well as the COVID credit sell-off and spread widening in 2020.
Source: Bloomberg and Eaton Vance, as of 12/30/2022.
Bottom line: While we would argue that the HY muni market, like other markets, can be difficult to time, we view the beginning of 2023 as a good entry point for HY muni bonds for the following reasons:
- Credit spreads are significantly wider now than a year ago.
- It is unusual for the HY muni index to underperform the IG muni index two years in a row.
- Over time, the HY muni index has outperformed the IG muni index.
Index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
1 Bloomberg Municipal Bond Index is an unmanaged index of municipal bonds traded in the U.S.
2 Bloomberg High Yield Municipal Bond Index is an unmanaged index of non-investment grade municipal bonds traded in the U.S.
