Muni bonds poised to deliver
Bottom line up top:
The gap narrows. Last week’s Consumer Price Index (CPI) report appears to have broken the back of market prognosticators hoping to outlast the U.S. Federal Reserve’s fight against inflation. Coupled with an upbeat payrolls report, January’s inflation data pushed market forecasts for the terminal fed funds rate north of 5%.
Higher-for-longer interest rates could lead to elevated volatility for certain assets, including equities. But, other assets could find fertile ground before the Fed soon reaches a restrictive interest rate level and achieves its goal of stabilizing prices.
Late cycle for rate hikes, early innings for municipal bonds. At some point in 2023, as inflation decelerates, we anticipate the Fed nearing the end of its rate hike cycle.
In terms of fixed income allocations, this environment should favor longer duration, steeper yield curves and more discerning credit selection. In particular, municipal bonds appear poised to deliver attractive total returns for investors, with compelling taxable-equivalent yields, especially as duration is extended (Figure 1).
Portfolio considerations:
Investment grade municipal bonds should provide attractive opportunities in select longer duration, undervalued high-quality bonds with the potential for income and total return. In 2023, new bond issuance is likely to be muted, and we think fundamentals remain strong. If the risk of a recession increases, risk-off investments should be more attractive.
Since high yield municipal bonds trend toward longer durations and higher yields, those investments should particularly benefit investors when both inflation and municipal rates decline. The taxable-equivalent yield of bonds in the Bloomberg High Yield Municipal Bond Index was nearly 10% as of 31 Dec 2022.
Credit fundamentals strengthened in 2021 and 2022 in the wake of the pandemic due to increased municipal revenue collections and significant federal stimulus funds (Figure 2). We remain constructive on credit, although fundamentals may experience some pressure in 2023 if the economy decelerates. Historically, municipals have provided positive returns even in the face of accelerating credit downgrades, as witnessed during the Global Financial Crisis.