From the Buy-Side: Municipal Value in 2022 by Dan Scholl, head of municipal fixed income, Wilmington Trust

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As we headed into 2022, the municipal market was far behind the taxable market in terms of preparing for the Federal Reserve (the “Fed”) rate-hiking cycle and persistent inflation fears. Consequently, municipal yields increased dramatically from extremely low levels at the end of 2021 which led to investors (especially retail municipal investors), selling their holdings, as daily declining mutual fund net asset values (NAV) and individual bond prices decreased dramatically. During the first nearly five months of this year, the municipal market experienced a surge of bonds for sale in the secondary market as mutual funds raced ahead to ensure they had requisite cash to meet redemptions. The result was that over $60 billion in net outflows were recorded—resulting in the eleventh outflow cycle since 1994 and the second-highest amount—beating the pandemic cycle at $50 billion but falling short of the 2013 taper tantrum level of $70 billion in outflows (source: JP Morgan).

As with most outflow cycles, municipal valuations became very cheap relative to historical standards as investors continued to sell and prices declined. The chart below shows the continued price declines in municipals from the beginning of the year through early June looking at the Bloomberg Barclays Municipal Bond Index, a good market proxy. Peak to trough, prices declined by almost 11% through mid-May and have recovered slightly since then for a cumulative return of -10% since beginning of the year (Source: Bloomberg).

SB 19 is not the first legislation of its kind, and it likely will not be the last. In 2017, the Texas Legislature passed a similar law, HB 89, with the same kind of contracting restrictions, but also with divestment requirements, for companies that boycott Israel (as amended, the “Boycott Israel statute”). In 2021, in addition to SB 19, the Texas Legislature adopted SB 13, which is modeled directly after the Boycott Israel statute and imposes both contracting restrictions and divestment requirements on companies that boycott the oil and gas industry.

Source: Bloomberg. Data as of June 17, 2022.

As in most outflow cycles, municipals get cheap enough relative to other investment alternatives, such as U.S. Treasuries and corporates, that nontraditional municipal buyers—e.g., banks, insurance companies, hedge funds and overseas buyers—tend to become engaged in the municipal market. Banks and insurance companies in particular can buy both taxable fixed income securities and tax-exempt municipal securities depending on the value and quality due being taxed at the 21% tax rate (which is lower than the top tax rate for personal income taxes at 37%1). As soon as the yield of a highly rated municipal becomes attractive to the yield of a comparable corporate bond depending on the buyer’s tax rate and guideline considerations, crossover buyers can provide strong support. Crossover buyers are traditional buyers who participate in taxable fixed income. Namely insurance companies, and life insurers. When tax-exempt municipals get cheap enough, these buyers enter/re-enter the market which can lend itself to offering a support to the downside. Crossover buyers use municipal bonds as a relative value asset class. So, if it makes sense they will enter to participate. The market saw that support in action in mid-May as buyers over several days bought high-quality municipals and the market rallied over 0.40%. The chart below shows the increase in the 10-year AA-rated municipal-to-corporate ratio (municipal yield divided by the corporate yield) and illustrates the strong buying when municipal-to-corporates ratios got close to 85% and are now trending lower to more standard levels (72% as of June 6, 2022).

Source: Bloomberg. Data as of June 17, 2022.

While crossover buyers have recognized the value in municipals, the same opportunity is still available for traditional buyers. Individual buyers, through mutual funds, ETFs, or individual bond holdings are able to earn appropriate after-tax returns in municipals at high levels of credit quality. Over half of the municipal market comprises retail buyers who may benefit from the after-tax value that municipals represent.

In all of the last 11 outflow cycles going back to 1994, after a period stress, traditional as well as marginal buyers re-entered the market and provided much-needed demand to achieve positive returns. While each outflow cycle is different, the municipal market still exhibits an undersupply condition where the demand traditionally outweighs the available supply as individual investors desire the relative stability and after-tax value municipals can provide.

Additionally, municipal issuers generally are at their highest level of fiscal health as tax receipts continue to be strong, and the federal infusion of monies to combat COVID-19 and provide economic support for state and local governments has led to record cash reserve balances by those entities. For example, California recently announced a record $100 billion in reserves and over 20 states have announced some version of a tax cut or rebate in their annual budget addresses. This current outflow cycle was caused by the Federal Reserve hikes and inflation fears—not a fundamental threat to municipal credits—so if you can weather perhaps more rate volatility, the opportunity in municipals still exists.

Disclosures

Advisory Service Providers

Wilmington Trust is a registered service mark used in connection with various fiduciary and non-fiduciary services offered by certain subsidiaries of M&T Bank Corporation including, but not limited to, Manufacturers & Traders Trust Company (M&T Bank), Wilmington Trust Company (WTC) operating in Delaware only, Wilmington Trust, N.A. (WTNA), Wilmington Trust Investment Advisors, Inc. (WTIA), Wilmington Funds Management Corporation (WFMC), and Wilmington Trust Investment Management, LLC (WTIM). Such services including trustee, custodial, agency, investment management, and other services. International corporate and institutional services are offered through M&T Bank Corporation’s international affiliates. Loans, credit cards, retail and business deposits, and other business and personal banking services and products are offered by M&T Bank, member FDIC.

Sources The information in this presentation has been obtained from sources believed to be reliable, but no representation is made as to its accuracy or completeness. Municipal bonds typically provide a lower yield than comparable taxable bonds in consideration of the tax-advantaged status of the interest payments from these bonds, which are exempt from federal taxes and may be exempt from applicable state and/or local taxes in the states and/or municipalities where they were issued. Capital gains do not share this tax-advantaged status. Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. The Alternative Minimum Tax may negate some or all of the tax benefits available through municipal securities.

Fixed Income Risks

Interest rate risk Prices of fixed income securities rise and fall in response to changes in the interest rate paid by similar securities. Generally, when interest rates rise, prices of fixed income securities fall. However, market factors, such as the demand for particular fixed income securities, may cause the price of certain fixed income securities to fall while the price of other securities rise or remain unchanged. Interest rate changes have a greater effect on the price of fixed income securities with longer durations. Duration measures the price sensitivity of a fixed income security to changes in interest rates.

Credit risk Fixed income securities carry the risk of default, which means that the security issuer fails to pay interest or principal when due. Many fixed income securities receive credit ratings from services such as Standard & Poor’s and Moody’s Investor Services, Inc. These services assign ratings to securities by assessing the likelihood of issuer default. Lower credit ratings correspond to higher credit risk.

Fixed income securities pay interest, dividends or distributions at a specified rate. The rate may be a fixed percentage of the principal or adjusted periodically. In addition, the issuer of a fixed income security must repay the principal amount of the security, normally within a specified time. Fixed income securities provide more regular income than equity securities. However, the returns on fixed income securities are limited and normally do not increase with the issuer’s earnings. This limits the potential appreciation of fixed income securities as compared to equity securities. A security’s yield measures the annual income earned on a security as a percentage of its price. A security’s yield will increase or decrease depending upon whether it costs less (a “discount”) or more (a “premium”) than the principal amount. If the issuer may redeem the security before its scheduled maturity, the price and yield on a discount or premium security may change based upon the probability of an early redemption. Securities with higher risks generally have higher yields.

Call risk Call risk is the possibility that an issuer may redeem a fixed income security before maturity (a call) at a price below its current market price. An increase in the likelihood of a call may reduce the security’s price.

Opinions and Estimates Any opinions or estimates contained in this presentation constitute Wilmington Trust’s judgment as of the date of these materials and are subject to change without notice.

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