Let's Not Forget About Munis!

Across all asset classes, there is a re-calibration taking place that is desperately trying to gauge the impact of a new Fed order that will lift short interest rates away from an extended term of zero-bound and eventually thin out the Central Bank’s balance sheet. As we consider the performance within the muni asset class, we think about what should have been. The technical backdrop during the closing weeks of 2021 positioned municipal bonds well heading into a traditional “January Effect”. Rather, the concern over the course of Fed policy has catalyzed a MTD/YTD loss in the general Municipal Bond Index. While munis are presently outperforming the UST index, we note that the performance spread between the two asset classes has narrowed considerably. The muni out-performance within fixed income is even more visible when compared to corporate bond returns. The January losses of record significance will certainly define the opening month of the new year and will likely generate a more guarded bias for investors going forward. The pathway to higher interest rates will likely test the boundaries and resiliency of munis, yet we remain confident that the continuity of tax efficiency, above average credit quality, defensive qualities in a rising rate environment, and diversification attributes will preserve market resiliency. Nevertheless, munis have not been able to escape the spate of fixed income outflows with investors pulling cash out of municipal bond mutual funds, breaking a 45-week run of positive flows and highlighted by sharp ETF and high-yield redemptions. While bid-wanted activity did not weigh heavily upon the muni market in 2021, bid lists throughout January posted the largest amount of secondary offerings since April 2020 according to Bloomberg.

Given the rate volatility that will likely characterize fixed income throughout 2022, munis can be expected to more closely follow the directional movements of UST yields during much of the year. However, there will likely be breakaway points as demand is expected to hold in and this could become more pronounced should the higher tax narrative re-emerge. At this point, we are not calling for an extended period of negative flows, but we can expect to see more intermittent outflows. We are already witnessing a sharp deceleration in the pace of inflows. Available cash remains plentiful, yet there will likely be a cautionary bias as to its future deployment. For now, we are holding to our initial forecast calling for modestly positive muni returns for 2022 and out-performance over UST and IG corporates for the year. Getting there, however, will likely encounter more stubborn headwinds. Having said this, we will closely watch investor demand patterns and any extended weakness in this technical barometer could alter our performance expectations and lead to negative returns for the year.

Our message to muni investors remains clear. Let’s stick to our knitting and recognize the value proposition offered by municipal bonds. The asset class begins the new year from a position of credit strength, thanks in large part to available stimulus, and is poised to only improve further as the recovery moves forward. We expect demand to remain active, albeit with potentially less enthusiasm at times, thus deterring any thoughts of a crisis in fund flows. We also believe that market conditions are creating more compelling entry points, which should prove beneficial to the long-term investment horizon. As we have been pointing out for the past few months now, munis tend to outperform other fixed income assets during periods of rising interest rates, and we do not foresee an exception during this cycle. Again, sector and security selection is of critical importance and investment quality accounts should focus on resilient credits offering well-crafted structures and ample protection of debt service while providing a high degree of portfolio diversification. This strategy has a proven track record of success and should help greatly to insulate muni portfolios from the volatility caused by movements to higher rates as well as from the vagaries of more pronounced credit distinctions.

For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Professional.