After a volatile January with rapidly rising rates and higher municipal to U.S. Treasury ratios, analysts expect investors to come off the sidelines in the remainder of the first quarter as more opportunities have emerged.
“Quarter one has sold off too far and too fast, creating opportunities — not only for the rest of Q1 — but for the rest of 2022,” Roberto Roffo, managing director and portfolio manager at SWBC Investment Company said.
January will go down in history as the month with the greatest loss since index records began in 1980. No sector was spared, with losses ranging from 0.66% in short maturities to nearly 3% in long maturities.
January’s selloff moved long-term bond ratios above 90% of Treasuries, which is close to the five-year average and just below the 10-year average, Roffo noted.
“This has created opportunity across the municipal market in general with the opportunity to buy certain bonds over 100% of Treasuries,” he said.
As the market turned the page to February, some skittish investors are still worried, according to experts, but they expect that concern to slowly dissipate now that the Federal Reserve Board unofficially announced plans to hike interest rates in March.
Indeed, the first two sessions in February have seen triple-A benchmark yields falling and investors coming back into the market in constructive two-way flow. Thursday’s session was also seeing strength.
Fear over rising rates led to the municipal market’s first cash outflows after 45 consecutive weeks of inflows in the latest reporting week.
“While I believe that cash flows will turn positive again, it may take a little while for retail investors to get comfortable with the current environment,” Roffo said.
Sharp exchange-traded fund and high-yield redemptions also damaged the previous 45-week trend of inflows, said Jeff Lipton, managing director and head of municipal credit and market strategy and municipal capital markets.
“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,” Lipton said, quoting Bloomberg data.
At the same time, both Roffo and Lipton said market fundamentals will continue to promote opportunity as the quarter progresses.
“The fundamentals for the municipal bond market haven’t changed and still show an improving trend,” Roffo said, adding that credits continue to maintain strong balance sheets and in some cases are getting stronger due to stimulus checks from the federal government.
Current market conditions are creating more compelling entry points, despite recent mutual fund outflows and lingering investor fears over rates, according to Lipton.
Those entry points should prove beneficial to the long-term investment horizon, beyond the first quarter, he said.
“Munis tend to outperform other fixed-income assets during periods of rising interest rates, and we do not foresee an exception during this cycle,” Lipton said. “Munis, however, ended the month ahead of investment-grade corporate bond performance.”
Lipton said the path to higher interest rates will likely test the boundaries and resiliency of municipals in the remainder of the quarter.
But, like Roffo, Lipton pointed out the classic fundamentals of the municipal market, such as its continuity of tax efficiency, above-average credit quality, defensive qualities in a rising-rate environment, and diversification attributes that will preserve market resiliency.
Lipton said sector and security selection is critical 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.”
He said this strategy should help greatly to insulate municipal portfolios from the volatility caused by movement to the higher rates expected in the remainder of the quarter.
The market remains driven by the supply-demand dynamic and the swift increase in yields, according to Eve Lando, portfolio manager at Thornburg Investment Management.
The moves in January were surprising, she said, but the volatility was a welcome change compared to last quarter.
“For the long-term investor, levels reflect the risk and carry more of a benefit of being a bondholder,” Lando said in a recent interview. “The overall view is it is moving in the right direction, reflecting more of true borrowing costs and more reflective of where inflation is and the relationship of ratios to the Treasury market.”
A widening of spreads due to increased secondary trading in 2022, as well as higher yields, has been more dramatic in municipals than Treasuries, with the 10-year triple-A municipal benchmark up over 65 basis points from a year ago, she said.
“That was a direct response to Treasuries and the expectations of rates going higher,” and investors wanting more compensation given the current inflation scenario, Lando said.
Secondary trading was virtually nonexistent in 2021 since investors didn’t want to part with or trade their bonds because municipals yields were so low and not reflective of the risks, she said.
So far in 2022, the rise in Treasury yields has created a powerful reversal of secondary trading that is roughly two times the average volume, Lando said.
The expectations of rising short-term rates in the first quarter makes short-term yields appear weak, and that is contributing to the sudden burst of secondary trading, according to Lando.
“Selling could yield better pricing because of the yield rise, and if you part with lower-yielding, lower-return positions and add on more yield, that translates into higher return,” she said.
An improving tone will follow through in the remainder of the first quarter, following incremental softness that impacted the short end of the municipal yield curve, according to Wesley Pate, senior portfolio manager at Income Research + Management, which manages $96 billion total assets, including municipals.
“The nearly 60 basis points higher in rates so far has really moved the needle much closer to what would be in line with more rate hikes than originally forecast,” Pate said in an interview.
“We see incremental softness in the Treasury market cascade its way into muni market,” Pate said, adding that the softness caused investor fears to exacerbate the January selloff.
“It’s interesting to note just how much the muni market is incrementally taking cues from the Treasury market and moving in lock step,” he added. Munis were mostly decoupled from Treasuries in 2021.
Going forward, rates aren’t expected to climb to the same degree as in the start of the year, as incremental Fed policy actions are reflected in current valuations, Pate noted.
While he expects to see relative softness in the market in the first quarter, what has been surprising is the market’s reaction to expected Fed policy changes, which Pate said on Tuesday has been “overdone in the last couple of days.”
Now that the forecast of rising rates is officially on the horizon, Pate expects opportunities to arise from the greater widening of spreads due to the incremental softness in lower-rated securities compared to higher-rated securities, such as single-A versus triple-B securities.
He pointed to pockets of opportunity in the housing sector as well as other lower-coupon securities in the current market with 3% coupons or less that are underperforming that of 4% and 5% coupons.
Lando said she believes the second quarter will provide more opportunities for investors, predicting more demand, continued healthy secondary trading, and more issuance compared to January through quarter end.
Higher yields should begin to attract investors back into the municipal market, she added.
“It’s been a long time since investors have seen rates go higher,” Lando said. “Now that rates are higher, it makes investing in the asset class that much more attractive.”
“Munis continue to serve as a safe haven,” Lando said, adding, she expects municipals to hold their value and gather assets, reflecting the increased attractiveness and flight to safety.
“There will be more pros than cons to the muni market, and will look more attractive than 2021,” Lando said.