Here's a Story of a Bond Named Muni
- November 2, 2022
When it comes to monetary policy, 2022 will likely go down in the books as one of the most historically relevant years with almost every one of the eight sessions commanding global attention. Admittedly, out-sized inflation has proven to be a stubborn adversary and we are seeing that the effects of the Fed’s aggressive tightening cycle have yet to produce consequential results with achieving price stability. While we understand that today’s enduring inflation has been catalyzed by a number of unprecedented factors, we do believe that patience must be applied throughout the tightening cycle as the higher rate backdrop is poised to break the inflationary fever over the foreseeable future and that the Fed must find comfort with allowing the pause narrative to take shape. Perhaps the time to bring the “front-loading” of tightening policy to an end is upon us. In our view, the Fed can achieve its desired target on its funds rate, but the road to get to its restrictive policy objective does not have to be carved in stone. 2023 is quickly approaching and we continue to believe that we are at or approaching the peak in bond rates. In our view, current UST trading ranges seem to be in the right zip code to account for the most likely restrictive scenario.
The economic backdrop is telling us that monetary policy is having its intended impact of slowing growth and curtailing demand, yet the data continues to support a robust labor market with low unemployment and advancing wages. While prospects for recession in 2023 have increased, we are betting on a number of resiliency factors to deter a deep and protracted contraction. Although the global tightening cycle may have taken on a synchronized performance as historic levels of policy stimulus needed to be removed from the system, the pathway to pause, pivot, and pursue an easing posture will likely occur at different times and speeds.
After spending much of last week flexing its independence muscle with tax-exempt yields backing up despite more favorable technical considerations and rallying U.S. Treasuries, munis held steady in front of the FOMC meeting. Even with the muni under-performance during the last week of October, the asset class outperformed UST for the entire month, with respective losses of 83 basis points and 1.39%. The Fed’s pathway to arrest uncontrolled inflation by pursuing a restrictive interest rate policy has created a sea of red throughout fixed income, yet munis are out-performing UST and corporate securities YTD, with negative returns of 12.86%, 14.3%, and 19.56% respectively. The longest dated maturities, 20 years and out, significantly underperformed the broader muni market last month as that part of the curve played catch-up to the UST sell-off at certain points during the month and saw active bid lists with attendant heavy withdrawals from municipal bond mutual funds.
Voting outcomes at the state and local levels can be quite significant as future policy decisions can affect tax initiatives, spending priorities, business climate, and local infrastructure projects – all of which could ultimately have implications for municipal credit.
During last month, revenue bond losses doubled those incurred by G.O. bonds, (-)1.03% versus (-).51% respectively, as investors focused on still-favorable tax receipts and comfortable fund balances associated with full faith credit issuers, and found themselves more cautious given challenged outlooks over certain revenue bond sectors. Certain cohorts within the hospital sector are experiencing above average margin compression given inflationary conditions, heavier spending needs and staffing deficiencies; housing stress is being felt more for local/conduit issuers experiencing competitive forces and weak management than with state housing agencies demonstrating greater asset diversification, stronger collateralization levels, skilled management oversight, and ample program reserves; the transportation sector remains under operational pressure as a number of systems struggle to regain pre-pandemic utilization. The high-cost of a traditional college education taken within the context of a COVID-induced lockdown has placed heavier scrutiny on college and university financial operations as the cost/benefit analysis has taken center stage. The higher education sector will likely become even more competitive and those institutions that have not differentiated themselves within a field of active liberal arts schools are most at risk of future enrollment declines and margin erosion.
The market volatility brought on by aggressive Fed tightening policy has kept a number of issuers sidelined, particularly as each and every FOMC meeting is billed as consequential. This dynamic certainly impacts pricing, placement and performance and makes for a very uncertain market. Having said this, market behavior has been efficient with deals receiving favorable reception. Next week’s mid-term election will be pivotal as the balance of power in Washington D.C. may be shifted should the Republicans take control of the House and/or Senate. As of this writing, while there is a greater likelihood of a GOP-controlled House of Representatives, certain key races for the U.S. Senate have tightened in, thus weakening the chances for Democrats to retain control of the Upper Chamber of Congress. Republicans need only one victory to capture the Senate. With a Republican majority in at least the House, any agenda for tax increases and new regulatory oversight for businesses from the Biden administration would likely be DOA, and there could be renewed tensions surrounding the U.S. debt ceiling. Away from the Federal contests, there will be 36 gubernatorial races and a vast majority of state legislative seats will be decided. Voting outcomes at the state and local levels can be quite significant as future policy decisions can affect tax initiatives, spending priorities, business climate, and local infrastructure projects – all of which could ultimately have implications for municipal credit.
For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Professional.