Historically for muni bond investors, the summer months feature a market awash with investable cash resulting from high volumes of redemptions and coupon payments.
This year, however, traditional seasonality is a bit less clear, according to Riverbend Capital Advisors Founder Tom Hession. With elevated interest rates contributing to muted issuance levels and uncertainty about further U.S. Federal Reserve rate hikes and the general economic outlook, even the potential for an above-average bump in redemptions may not be enough to bring yields down considerably.
“Things may yet stabilize or reverse in the coming weeks, but through much of May, munis consistently sold off, keeping up with the higher rate trend on U.S. Treasuries,” Tom said. “As we turn to June, July, and August and consider the new cash hitting the market alongside the limited supply—especially in new issuance—investors may ask ‘To what degree might macro or market dynamics overwhelm the muni rollover?’”
Recently, Tom provided deeper insights on the current landscape and potential opportunities as well as Riverbend Capital’s strategic thinking amid the bond market’s ongoing turmoil.
An influx of cash should bolster demand. What’s different this year?
Oftentimes, the abundant proceeds from summertime maturities, call dates, and coupon payments are good for muni market technicals and supportive of muni bond valuations. The market dynamic of available funds outstripping supply is commonly known as negative net supply, and while it’s a fairly regular occurrence, this year may be different.
More specifically through the first part of 2023, we’ve seen steady outflows from muni bond mutual funds, which diminishes demand. On the supply side, new tax-exempt issuance in 2023 has been running 20% lower than 2022’s depressed levels and we believe the higher-rate environment has caused some issuers to shelve deals or hit the pause button. Frankly, I think a lot of municipalities and states got used to issuing bonds at very low yields, so today’s higher rates receive much more significant consideration.
"The market dynamic of available funds outstripping supply is commonly known as negative net supply, and while it’s a fairly regular occurrence, this year may be different."
How is the broader macro environment undermining such muni-specific conditions?
It really all comes down to the Fed’s thinking on rates and the market’s perceptions of their thinking. Whenever market sentiment changes or there is anticipation that the Fed is going to pause or even start to lower rates, I think we’ll see that get priced in quickly across the yield curve.
How will we know change is afoot?
Importantly, the shift probably won’t be delivered in an actual announcement, but it will be reflected in the language and talking points of Fed officials or governors. Just a couple of words here or there from a Fed policymaker could really move the market’s expectations.
For example, given how much they’ve stressed the concept of keeping rates higher for longer, if they stop referring to that, I think many will take that as a sign of potential recession or economic slowdown, and that they’re weighing rate cuts. Or, they may say they want to see how these rate hikes play out through the economy, which would probably be perceived that a pause is in play.
How has the muni bond market been rolling with higher interest rates?
Overall, I believe today’s higher yields are generally good for muni investors and represent an especially good alternative for those in higher tax brackets. Nobody knows where things are going to end up but yields on the longer end are such that when you’re looking at taxable-equivalent’s in the mid-6s or maybe closing in on 7 percent, those are equity-like returns with high-quality bonds. Could yields go higher? Yes, they could. But it seems to me that being able to lock in a yield like that on a high-quality bond is something you probably won’t regret in one year, three years, or beyond.
From a credit perspective, states and local governments are largely well-positioned for whatever economic slowdown is on the horizon, as many reserve funds are sitting at record highs and tax receipts are strong in many places. Furthermore, if rates do decline, that’s supportive of valuations and if they drop across the yield curve, we’ll probably see a boost in issuance among municipalities and states that held back as rates rose.
"Overall, I believe today’s higher yields are generally good for muni investors and represent an especially good alternative for those in higher tax brackets."
Has the present landscape affected your approach to portfolio construction?
Generally, inflation and the higher interest rates deployed to fight rising prices are bad for much of the economy. Yet, such conditions have been helpful in opening up opportunities for people to establish bond portfolios or add to existing portfolios at much more attractive yields at both the short and long ends of the yield curve. That’s why, lately, we’ve been focused on a portfolio strategy outside of our normal approach—a barbell structure.
A barbell strategy? Away from the weight room?
Yes, a barbell is actually an apt description of how we’re positioning portfolios of late. A significant portion is dedicated to bonds with durations of 18 months or less offering attractive yields in keeping with short-term Treasury rates. The balance of the portfolio is largely invested in longer durations, beyond 10 years. That’s longer than we typically invest, but the yield curve is steep in that range and the jumps in rates from year to year are significant.
Overall, we believe this approach offers good balance for individuals who want to stay flexible and somewhat cautious with select short-term positions but don’t want to miss out on the current yield opportunities in longer durations. For example, once a short-term position matures in six months or so, maybe we put that into an intermediate bond, go longer, or remain in the short-term market, depending on what the market looks like when that rolls off. Meanwhile, the long-term issues will continue to generate steady returns. What’s nice is that in this environment, investors can generate income on a muni portfolio that they haven’t been able to for years, and we enhance that with our proactive portfolio management approach.
Please explain what you mean by proactive portfolio management.
We explore each client’s long-term objectives and determine how the capital preservation and tax-free income characteristics of muni bonds can provide the stability to counteract and balance out risk in other parts of their portfolios.
In practice, that means we’re constantly assessing the potential returns, risks, and overall impact of every holding in a portfolio. Just as our current barbell strategies are designed to be nimble on the duration front, we may find that the incremental additional yield on a callable bond is advantageous. Meanwhile, we regularly try to steer clear of more vulnerable issuers who simply aren’t offering enough yield to compensate for the inherent risks in their bonds. And when it’s appropriate to make adjustments in a client’s portfolio, as happened with beneficial tax swap opportunities as the market swooned in 2022, we’ll make the required moves.
The focus on our clients’ objectives begins with our initial investments as we structure their portfolios while preparing them for whatever volatility or adversity that may lie ahead. So, wherever the Fed goes in the coming months or however the seasonal influx of cash sways the broader muni markets, we believe we’ve positioned our clients’ portfolios to effectively weather the storms.
We encourage you to watch the replay of a recent webinar to learn more about Tom Hession’s approach to muni bond investing and invite you to connect with us to receive insights like this and other Muni Musings via email.
