FixedIncome

2022 Municipal Recap and 2023 Outlook

Jeffrey Lipton January 03, 2023

Printable Version

As we say goodbye to 2022, we do so with no love loss. There is no denying that 2022 was rife with volatility of historic proportion thanks to the Fed’s aggressive and unprecedented tightening sequence specifically orchestrated to break the grip of the highest inflation levels in 40 years. A dramatic repricing for both equities and fixed income has altered the asset allocation strategy with bonds taking on a higher profile given rather compelling and competitive yield and income opportunities, resulting in more than renewed contemplation over the 60%/40% asset allocation mix.

Although most fixed income security classes have endured double-digit losses in 2022, as measured by the Bloomberg Barclays U.S. Aggregate Bond index, they may continue to offer investment ballast as an offset to volatile price gyrations across risk assets.

We have arrived at a critical point in monetary policy with 2022 market movements significantly responsive to a combination of heavy messaging delivered through a series of Fed-speak and headline economic data points. Such unprecedented policy moves will undoubtedly have yet-to-emerge economic consequences. While further rate increases are widely anticipated in 2023, market valuations will be sensitive to the depths of the Fed’s restrictive journey.

The muni market is being teed up to enter 2023 from a relative position of strength. Credit quality remains strong across the broad array of muni sectors, absolute yields and attractive and competitive cash-flows provide a compelling argument to put sidelined cash to work, better relative value opportunities support future investment performance, and market technicals should bolster out-performance. Taxable equivalent yield calculations make the value proposition that much more apparent.

While muni performance ended 2022 in the red thanks to rising bond yields and accompanying price erosion, the attractive cash-flows have created a strong “carry” component to performance, providing an offset to the principal losses as well as defensive attributes ahead of a potential recession. This will likely extend into 2023, although we expect far less price erosion and perhaps there may be opportunities to experience some price appreciation. Muni performance is set up in 2023 for positive returns, which for now we project to be in the mid-single digits.

The muni asset class can be expected to deliver reliable income streams and diversification attributes to a cross-section of investors throughout 2023. The opportunities may very well come with unforeseen volatility and so appropriate entry points with an understanding of call optionality must be key to the investment calculus.

Policy actions to date have slowed certain sectors of the economy with housing activity being at the top of the list thanks to more burdensome mortgage rates that are running at a 15-year high and that have eliminated many first-time home-buyers and certain fringe interest from the borrower pool. Although we have seen some tempering, shelter inflation derived from out-sized rents will remain a headwind to inflationary containment throughout the near future. Food inflation, while easing a bit, remains unacceptably high. We are confident in our view that inflation has likely peaked and that the effects of Fed policy have been baked into the economic trajectory for some time now.

As we think about munis in 2023, we do so with guarded optimism as we recognize that sentiment can easily be swayed, especially if the technical dynamic loses its momentum. In response to shifting economic and interest rate conditions and to the overall expectations for inflation and a possible recession, municipal bond investors can take steps to mitigate the potential for portfolio devaluation by staying focused on the defensive attributes offered by municipal securities.

We continue to expect a break in the extended period of record mutual fund outflows as technicals return to the performance driver’s seat and monetary policy mayhem dissipates in a meaningful way. Of course, there will be the usual muni movement in lockstep with UST, but we can expect to see some social distancing as conditions guide tax-exempts to outperform in 2023.

A shift in flow patterns may not be present in the opening weeks of 2023, but we do expect to see more intermittent inflows with possibly an enduring string of positive flows later in the year. Investors are advised to pay close attention to spread relationships, especially if outflows linger with higher ratios, presenting meaningful buying opportunities.

Deposits into muni ETF’s have been the outlier in 2022 with continued allocations into muni ETF’s expected to accelerate in 2023 as this relatively young investment vehicle continues to offer attractive benefits and is seen as a viable place to allocate cash. Muni ETF’s are growing in popularity and are being sought after for tax-efficiency, a more compelling fee structure, diversification and above-average credit quality attributes.

Relative value ratios moved away from their proximity to historically tight levels in 2022 as long munis in particular grew cheaper to offer more compelling opportunities to crossover buyers. In 2022, we experienced a rare event in the muni market as an inverted yield curve emerged subsequent to overly rich valuations on display for ultra-short tenors. A cheapening bias tends to prompt institutional buyers to invest for greater value as opposed to just putting cash to work. As ratios return to their longer-term averages that are much closer to 100%, cheaper valuations with wider spread may enhance performance potential, yet technicals could directionally influence ratios.

Muni credit can be expected to demonstrate further resiliency entering 2023 as the economy continues to exhibit strength. Fiscal austerity should remain visible in 2023 as many municipal issuers are still carefully balancing their debt requirements against a number of other budgetary needs competing for limited resources, not the least of which are pension and OPEB liabilities. Unfunded pension liabilities and advancing OPEB obligations will continue to be a financial drag for certain municipal budgets.

Overall, muni credit quality continues to stabilize with a number of sectors approaching pre-pandemic financial and operational performance. Of course, we must be on the lookout for fresh COVID-related developments, which can slow the credit momentum, and K-12 public schools, higher education, mass transit and airports, as well as healthcare providers would be areas of primary focus. Once the various sources of Federal stimulus run out and the veil of protection is lifted, certain pre-COVID weaker obligors may have a difficult time reconciling their budgets and maintaining stable credit attributes, particularly those that have out-sized pension obligations, constrained demographics and marginal reserve balances.

Defaults/ Chapter 9 filings can be expected to increase in 2023, but should be primarily confined to the usual cast of characters such as certain types of project finance, conduit housing bonds, and lower quality healthcare financings. We can expect a rise in technical defaults with an increasing percentage of this group falling into actual monetary default with higher impairment experience.

While we do not expect a rating downgrade to any of the states in 2023 and believe that they are well-poised to address the impact of recession, there could be isolated downgrades on local credits. We suspect that a downgrade on a local government would cite one or more characteristics including limited budgetary and revenue-raising capacity, a lack of economic diversification, an increasingly challenged debt and contingency obligation position, shrinking reserve levels, and a management team ill-prepared to navigate its way through an economic contraction.

We believe that muni portfolio additions and realignment should be made with a disciplined eye toward quality and resiliency, and adherence to suitability needs and investment guidelines should position portfolios defensively to mitigate potential shocks throughout a monetary tightening cycle and to prepare for a possible recession in 2023. We strongly encourage these measures to avoid jeopardizing portfolio returns, credit quality, liquidity, cash flow and diversification. Periods of spread compression could help facilitate an upgrade in portfolio credit quality.

ESG will remain in the headlines in 2023 and beyond with climate change and threats representing a growing investment consideration for those affected areas of the country. A Republican-dominated House of Representatives and local GOP efforts could give rise to anti-ESG legislation that restricts ESG investment criteria. Should this scenario play out, we suspect that various fund managers will encounter challenges to their investment policies and that there could be an impact to the general issuance trends and appetite for ESG-centric investments. Bond disclosures continue to improve regarding climate conditions and remediation, yet transparency remains uneven.

Cyber-security concerns have been a growing part of the 2022 investment narrative and will likely intensify in 2023 and beyond for municipal governments and their enterprise units. The risks to municipal credits are rising, especially where cyber-attacks are fueled by financial gains. This is a clear and present threat to all facets of our way of life that could gravely disrupt our nation’s financial system, array of infrastructure assets, health care delivery protocols, communication and information technology networks, and the security of our food stock. Thus far, there have been various instances of cyber-attacks targeting municipal governments with the installation of ransomware making access to critical data problematic, and we have even seen rating agency downgrades due to the financial impact, with cybersecurity risk becoming an even more prominent aspect of the credit assessment process.