As the municipal bond market recovers from the whiplash that was 2022-23, we sense the emergence of a different mindset among muni investors.
Call it sophistication—or perhaps common sense—as increasingly there seems to be more recognition around the benefits of owning a portfolio of individual bonds versus a mutual fund or ETF. Those easy in/easy out vehicles are perhaps better suited for a more efficient asset class such as equities, where a higher level of transparency stems from the open exchanges and redemptions are generally easier to manage.
Conversely, in the more-fragmented muni market, there is less visibility into transactions within mutual funds and ETFs. And when the market is falling and redemptions mount, it can be challenging for fund managers to sell much more than the highest quality securities.
Such liquidity dynamics in the mutual fund and ETF world sometimes create opportunities for those building and maintaining actively managed separate accounts (SMAs), as they can capitalize on temporary mispricing’s offering incrementally better yields.
A Breathtaking Rally Followed a Gloomy Downturn in 2023
Following the disaster that was 2022, in which the municipal bond market dropped just over 9%, according to the ICE BofA Municipal Securities Index, munis largely struggled through the first part of 2023, declining another 2% to 4%.
The muni market generally followed broader moves in the bond markets, which hinged on the outlook for the Fed’s key lending rate, especially related to the possibility of the end of the central bank’s tightening campaign and even a potential rate cut or two. Expectations shifted over the first half of the year as fears of a recession faded.
By the fall, lingering uncertainty over the Fed’s mood led to a selloff in bonds, and the downturn in munis was exacerbated by increasing supply levels due in part to new issue volume, mutual fund selling pressure and tax-loss harvesting. Taxable equivalent yields on high-quality issues passed the 7% mark and as the inverted yield curve flattened—due in part to a selloff in intermediate-term issues—stellar opportunities surfaced across the yield curve.
Already feeling good about locking generational highs in taxable equivalent yields, muni bond investors received another reward in November as the market jumped 6.3%. Not only did expectations that the Fed was done raising rates take hold, but anticipation of cuts in 2024 were once again priced in.
Rebounding Issuance in 2024?
Market volatility contributed to reluctance among some states and municipalities to bring new issues to market in 2023, especially as rates jumped early in the year and again in the fall.
By the end of November, issuance totaled $352.6 billion, according to SIFMA, trailing 2022 totals by about 5%.
Source: https://www.sifma.org/resources/research/us-municipal-bonds-statistics/
For 2024, underwriter Bank of America projects issuance will rise to $400 billion, including $300 billion for new projects, with the Fed’s actions and sentiments remaining a key variable.
With rates expected to retreat, we anticipate that issuance will grow in 2024 as selling new bonds is likely to become more attractive for cities and states. Plus, deals that may have been put on the back burner through the volatility of the last two years could finally come to market amid a renewed sense of calm.
To be clear, we don’t expect the floodgates to open, and we anticipate issuance will happen at levels that the market can absorb. Investor demand is solid and should provide enough support to easily handle the modest increase in issuance that many are expecting.
Credit Remains Strong
One trend we expect to remain largely unchanged in 2024 is the muni market’s skew toward higher quality securities and reduced credit risk.
Separate from the recent turbulence, we saw municipal credit perform extremely well in 2023. Through the last couple of years, there have been very few defaults, with those mostly confined to continuing care facilities like nursing homes or project-specific industrial development bonds rather than plain vanilla credits and essential service revenue bonds.
We expect the stability trend to continue, even with challenges in places like California, which is anticipating a budget shortfall. Rainy day reserve funds are at all-time highs. Most (though not all) state and local governments remain vigilant in terms of fiscal discipline. Municipal credit is resilient in economic downturns as municipalities and states have a wide range of options to balance budgets in terms of raising taxes, cutting services or programs, etc.
Similarly, we anticipate less broader volatility as the Fed appears done with its rate hikes, inflation keeps trending lower, and some collection of rate cuts could be in the mix.
With this expected stability, munis will likely track the fixed income market. Outflows reached record levels in 2022, and while there were additional outflows in 2023, they were less pronounced than the previous year.
Seemingly Surging SMAs
Fund outflows result in mutual fund and ETF managers selling, and in a down market, they frequently must exit better quality bonds that haven’t performed as poorly as others in order to meet redemptions. This dynamic can be a key point of differentiation for SMAs as they are positioned to take advantage of the opportunity to pick up those better-quality bonds at favorable prices.
The effect is somewhat anecdotal—unlike mutual funds, there’s no repository to collect data on the specific value of holdings of munis in SMAs, but recent industry analysis estimated it totaled around $700 billion.
And it’s a nuanced slice of the market where investors can look at the individual holdings within an SMA and determine if a sale makes sense—frequently after a conversation with the SMA manager. Perhaps a sale isn’t prudent at the present time, or maybe some tax-loss harvesting could be beneficial. The important points here being “control and access”.
Unlike a mutual fund or ETF, where the investor is essentially at the mercy of the behavior of their fellow fund shareholders, an SMA portfolio holds individual bonds with permanence and definition. There’s a fixed maturity date and a known coupon rate.
Our Approach on the SMA Front
Let’s revisit the benefits of investing in municipal bonds via a separately managed account:
- Better control and access to the manager.
- Full transparency into the holdings.
- Visibility on the impact of portfolio modifications.
We at Riverbend Capital appreciate the flexibility to help clients and advisors respond to market conditions. For example, when it made sense to adopt a barbell structure to capitalize on high short- and long-term rates in mid-2023, we worked with clients to make that happen. Similarly, in 4Q 2023, we were finding value all along the yield curve, so we added exposure in the intermediate space.
That flexibility also extends to the places we’re investing—or not—depending on our risk-return analysis. At year-end, that translated into strong interest in Texas, where an ample supply of very high-quality bonds traded at reasonable valuations due in part to the lack of a state income tax. Conversely, in general market portfolios we mostly avoided issues from high-tax states such as California and New York where tax exemptions for income from in-state bonds have driven spreads to very tight levels that don’t make sense if you don’t live there.
Ultimately, our investment decisions are driven by our clients’ goals and objectives, and we continue to navigate this fragmented market while serving as an advocate for our client’s best interests.