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March 22, 2022

How Much Is Enough?

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March 22, 2022

How Much Is Enough?


Insight Article

How Much Is Enough?

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March 22, 2022

 
 

This year is clearly different than last year, and the market correction in tax exempt munis has been severe and protracted. The question now at hand is “How much is enough?” While the drivers of higher rates and market volatility are obviously not the same as this time last year, there are some interesting parallels that may offer clues to scenarios for the balance of this year’s muni market performance.

In similar fashion to our bi-weekly audio series approach, the following text will try to concisely cover “Where we have been, where we are, and where we may be heading.” In this case, on a full-year basis.

 
 

Before getting into the timelines, it is worth mentioning that muni market volatility during the last two months has driven tax exempt yields sharply higher, and that increase has now made the short-end much more attractive on a nominal yield basis than it has been since the pandemic dislocation in early 2020. Looking further out the curve, both 10-year and 30-year benchmark munis have also returned to levels that have not been seen since the tail-end of the pandemic-driven volatility of March- April 2020…levels that should beckon additional investment.

In the aftermath of the January to mid-February rout and related yield curve flattening, a rare climate has emerged where multiple strategies can be considered viable options for individual investors. These include short duration for those who believe in persistent inflation, ladders for a more measured multi-year approach and intermediate duration for those who feel, as we do, that much is already in the price. We are even approaching levels where long duration may have its day in the sun, but there is still a caution flag waving. Should volatility materially subside in the near-term, long duration tax-exempts may indeed represent value for the long-term.

Where we have been:

In terms price changes, January through mid-February looks more like a year than a month. Benchmark 10-year AAA yields began their ascent in early-January and just kept going. Along the way, the muni market recorded its worst January since at least 1980. While the swiftness of the move was striking, it did have a familiar feel to it, as a similar “catch-up” pattern to rising U.S. Treasury (UST) yields took place approximately one year ago. And what happened after is interesting.

After outperforming UST yields for weeks during February of 2021, and setting an all-time low of 55% for 10-year relative value along the way, the muni market then rapidly corrected and set the high 10-year muni relative value level of the year, at 81%…on March 2nd. Subsequent trading sessions brought stability back to munis and the relative value quickly returned to the mid-60% range, which turned out to be the average relative value level (67%) for the full year.

Fast forwarding to the current period, the muni market cruised through December largely unchanged, even as UST yields rose 15 basis points (bps) for the month. Once 2022 began, the muni market rapidly corrected throughout January and into mid-February in the face of rising supply followed by relentless selling pressure, bringing the 10-year muni to an impressive 87% of USTs on a relative basis. What makes this time different is that the correction spanned weeks and was more severe than the 2021 experience, driving consecutive weeks of muni mutual fund outflows (see Display 1 - Fund Flows). Until muni yields stabilize, the near-term prospect of additional outflows and related market volatility endures.

 
 
 
Display 1: Muni Mutual Fund Flows
 

Source: Lipper, as of February 23, 2022.

 
 

The other possible “fly in the ointment” is the potential drift toward higher year-end UST forecasts. As we have discussed before, tax exempt munis are vulnerable to supply/demand imbalances that often develop in seasonal patterns, which typically impact relative value levels. We will discuss this further in a moment, but for now please note that year-end UST forecasts are key in determining where tax exempt muni yields may ultimately reside. Additionally, these seasonal imbalances can provide opportunities for both prospective buyers and sellers, depending on the weighting of the imbalance. When such muni-specific imbalances coincide with broader rates volatility, the related moves in nominal muni yields can be considerable. Accordingly, the chart below (Display 2) illustrates expected municipal bond redemptions, a key source of reinvestment demand, for the balance of the year. Considering the market’s hyper-focus on the mid-March FOMC meeting (and the related possibility of rates volatility), paired with the expectation for a lull in reinvestment demand for March, April and May, an extension of today’s favorable entry points may be in order.

 
 
 
Display 2: Total 2022 Muni Redemptions
 

Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass. Source: ICE, as of February 17, 2022.

 
 

Where we are:

As we pen this note, 10-year benchmark muni yields are at 1.66%, after rising as high as 1.71%. Except for a two-week “dislocation” period at the beginning of the pandemic during March/April 2020, the 10-year benchmark is at its highest level since May of 2019 (see Display 3). In fact, despite being only in the first quarter of the year, investors interested in conducting tax-loss swaps are already in position to do so.

 
 
 
Display 3: AAA 10 Yr Muni GO Spot Yield
 

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions. Source: Refinitiv, as of March 1, 2022.

 
 

In terms of relative value versus corresponding maturity USTs, 10-year tax exempt yields stand at 95%…above the current year-to-date high and well above both last year’s high and average of 81% and 68%, respectively (Display 4). However, when viewing muni relative value in today’s market, it is worth noting that the UST denominator has been bouncing around quite a bit, given ebbing and flowing concerns over geopolitical developments regarding Russia-Ukraine, which has quickly overshadowed the bond markets’ otherwise intense focus on pending Fed actions and related inflation growth. This has caused the muni relative value metric to fluctuate significantly, literally from day to day. That said, muni-to-Treasury relative value relationships should be treated as subject to significant change until the near-term flight-to-quality bid for USTs abates.

 
 
 
Display 4: AAA 10 Yr Muni GO Relative Value
 

Source: Refinitiv, as of March 1, 2022.

 
 

Where we may be heading:

As mentioned, relative value levels can help determine where munis may end the year based on UST forecasts. Accordingly, Display 5 (below) employs Morgan Stanley’s 2022 forecast for 10- year USTs and applies three probable muni-to-Treasury relationships. At current levels, and as illustrated below, today’s muni yield exceeds, or is in close proximity to, two of the three likely year-end scenarios. As an aside and for context, the “street” consensus forecast according to Bloomberg on 3.08.22 has the 10-year UST note at 2.03% by mid-year and 2.21% by year-end 2022.

We are using the more conservative Morgan Stanley forecast.

 
 
 
Display 5: Rate Forecast - Munis vs. UST
 

Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass. Sources: Refinitiv and Morgan Stanley, as of March 1, 2022.

 
 

What to do?

Given this context and perspective, combined with some of the year’s lowest redemption months and the prospect of typical pre-tax filing muni weakness, it appears that an extended opportunity to capture tax exempt value may indeed be at hand. To be sure, volatility may continue, as UST yields are widely expected to rise in the coming months, especially as we approach the Fed’s much anticipated first rate hike in mid-March (aka “liftoff”), but as illustrated in our forecast chart, the recent move in munis has vaulted yields into a range where much is in the price and further downside may be limited in light of current year-end forecasts. Stay tuned!

 
 

Risk Considerations

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Municipal securities are subject to early redemption risk and sensitive to tax, legislative and political changes. Taxability Risk. Changes in tax laws or adverse determinations by the Internal Revenue Service (“IRS”) may make the income from some municipal obligations taxable. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company’s portfolio securities. In addition to the Portfolio’s fees and expenses, the Portfolio generally would bear its share of the investment company’s fees and expenses.

 
john.dillon
Managing Director
Fixed Income Managed Solutions
 
 
 
 

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