Fixed income investment experienced a challenging H1 in 2022, amid increased geopolitical uncertainty, rising interest rates and soaring inflation. Against this backdrop, US municipal mutual fund outflows topped US$86bn during the first half of the year1, reflecting the difficult macro backdrop - led by aggressive Federal Reserve rate hikes - and high inflation data.
Yet in a fixed income universe swirling with uncertainty, Insight Investment head of municipal bonds, Dan Rabasco points to the continued resilience of tax-exempt municipal bonds. “The relatively defensive nature of tax-exempt municipals appears to have held up so far this year. In fact, there are very few global fixed income markets that have done better relative to tax-exempt municipals so far this year.
“To the extent that investors are concerned about interest rate volatility, we believe that return prospects for tax-exempt municipals should be superior over the medium term and in positive contrast to what we experienced in the first half of 2022,” he says.
In contrast, taxable municipal bonds – which attract investment from both US and non-US investors - have performed less well this year but, Rabasco adds, could also offer significant potential. “The yields on longer maturity investment grade taxable munis are the highest they’ve been in eight years and we believe could offer some attractive yield spread pickup to like rated corporates. A consideration for a non-US investor however is the current high cost of currency hedging,” he adds.
While overall recent outflows from municipal bonds remain of some concern, Rabasco believes it is a short-term phenomenon. Historically, he adds, the one-to-two-year time periods following some previous large municipal bond market drawdowns have shown a strong rebound, which may augur well for the market in the months ahead.
“Municipal bond markets can shift quite quickly and tend to bounce back just as fast. Although the current market conditions are far from ideal, we see some positive signals ahead,” he says.
“As we enter the latter half of the year, we believe there are several tailwinds that should support municipal bond performance on the back of a solid fundamental credit backdrop and strong seasonal reinvestment demand as we approach the end of the year.” Also, greater clarity on the macro-economic front, specifically the domestic inflation trend and Fed monetary policy could help temper overall interest rate volatility.
Rabasco believes fundamental credit conditions remain solid overall for many US state and local governments, aided by earlier federal support, waning Covid-19 cases, and favorable tax-revenue trends. “We continue to see opportunities in travel-related credits such as airports and toll roads, which have seen volumes recover to near pre-pandemic highs due to pent-up demand. So-called essential service revenue bonds2 in areas such as electricity supply, water and sewerage and waste disposal also appear to be holding up well,” he adds.
Geographically, some of the more prosperous US states benefited from strong federal government support during the pandemic. According to Rabasco this has helped some states strengthen their balance sheets and address specific shortfalls such as pension fund deficits.
“California, Connecticut, Pennsylvania, and New York State are among those states whose financial health appears to have improved over the past 18 months, though some states are still grappling with issues such as relatively weak pension scheme funding ratios,” he adds.
Rabasco believes the market, which has already shown resilience in the face of the increasingly challenged market, presents ongoing potential for longer term investors.
Looking ahead, beyond the current market volatility Rabasco see the emergence of environmental social and governance (ESG) friendly municipal bonds as a growing, if nascent trend in the US.
“The ‘green’ municipal bond market is still evolving. As far as responsible investment goes there is still little standardization in the US and the definition of what constitutes an ‘ESG bond’ is certainly less clear than it is in Europe, though that should change over time as the market becomes more sophisticated.
“Nevertheless, there is a well of potential in responsibly invested issuance and we are seeing an increase in the issuance of ESG-labelled bonds, notably in the green and social areas. The largest area of growth appears to be in social bonds, with many deals going toward affordable housing projects that aid low-income populations,” he concludes.
1 Source: Insight Investment/ Investment Company Institute, Bloomberg as of June 30, 2022
2 Municipal debt securities designed to finance projects in areas considered “essential”, like utilities.
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