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Written by: Michael Landrum | AAM
The best way that we can think of to describe the municipal (muni) market over the past year would be “orderly chaos.” We have experienced swings in rates and spikes in volatility, but the market never really felt off the rails as it did during the notable muni defaults in the early 2010s, or the week after Covid shut down the world economy. There is a fundamental underlying demand for consistent, predictable yields that are exempt from taxes, and after interest rates finally moved on from being just above 0% for years, buyers of muni bonds have descended on the market and made for a very interesting rising rate environment. On the municipal desk, we are expecting demand for muni bonds to remain extremely strong over the next few months. Our primary reasoning is simple supply and demand dynamics.
Looking at principal and interest returning to municipal investors and comparing it to the rest of the year, this summer is almost doubling the amount of cash coming back to market participants from municipal investments. For most of the year, the monthly total debt service has been $30–$35 billion, but beginning in June, that number almost doubled to $57 billion returning to investors. In the next two months, we can expect to have $48 billion and $55 billion principal and interest payments ready to reinvest back in the muni market. One quick metric we use as a snapshot for supply versus potential demand is the 30-day net supply number. This number takes the 30-day “available to reinvest” number (amount called and maturing but excluding interest) and subtracts the total announced supply coming to market for the next 30 days. As of June 18, there was $37.7 billion maturing or being called over a 30-day period and a total supply expectation of only $12.4 billion leaving the net supply at a massive negative $25.3 billion.
As JB Golden mentioned in his summer muni outlook last week, “above average supply is likely not going to continue, [and] demand normally outpaces supply during summer months.” If demand outpaces supply, we can reasonably expect prices to increase and yields to drop over the next quarter, even if it’s just measuring relative to Treasury yields. When yields drop, investors start looking lower and lower on the credit quality scale for yield. In munis, this means buyers specifically start looking to the high yield space. Lipper fund flows is a good visual for this phenomenon. The chart below shows total fund flows across all muni funds (dark blue) and the high yield only fund flows next to it (light blue).
Of the seven weeks of fund outflows we have had in 2024, five of those weeks have had concurrent inflows into high yield funds. The two weeks that were an exception to that were the first week of January and the week after taxes were due in April, which are two times during the year with more externalities if you are looking at capital flows.
We are coming up on an environment in which investors could be flush with cash to spend on municipal bonds and searching for areas of increased yield. We feel it is important to discuss an often-overlooked reality of municipal bonds: There is a distinct inflection point in risk when you cross over from A rated municipals to BBB rated municipals, but that doesn’t mean there is a particularly increased level of risk when you are looking at high yield munis. Default rates on high yield muni bonds are actually closely comparable to global corporates over the longer term, but when you are investing in A to AAA rated munis, 10-year default rates are extraordinarily low. Specifically, 10-year default rates on Aaa are 0.00%, AA rated are 0.02% and A rated are 0.1% as referenced below in an often-cited study done by Moody’s from 1970–2022. Investors selling investment grade munis to swap into high yield may be adding more portfolio risk than they realize.
Past performance is not indicative of future results.
While swapping into high yield may be appropriate for some, we believe it is a good idea to first genuinely reflect on the tax-equivalent yields of a bond compared to the level of risk added to a portfolio. The lower yields that come with tax exemption tend to play a psychological trick on us when we are looking at taxable yields and comparable value. However, considering the advantages in managing credit risk when looking at A rated and above municipal bonds, it is important to keep a logical approach, consider unique tax situations and estimate the tax equivalent yields for a given investment compared to the alternatives. Keep in mind that we are still investing at the highest tax-exempt yields in years and there are very good reasons why we are carrying significant momentum on the demand side.
Source: AAM, hypothetical tax-equivalent yields. For illustrative purposes only.
Muni rates are the highest in decades and A to AAA ratings are ideal from a risk management perspective in our view, but how does that translate when we are investing a diversified portfolio? Increased municipal demand along with futures-implied rate cuts and expectation of an overall lower interest rate environment would suggest extending portfolio duration and locking in yields while higher rates are still available. However, considering recent inflationary pressures and upcoming elections, we think it’s prudent to keep some much shorter-duration maturities available in order to reinvest in any opportunities that present themselves in the short term. For investors, this means that we favor a barbell strategy over a bond ladder at this point and will allow buyers to lock-in some of the higher yields while keeping some cash in short-term investments to come due in defined intervals.
From the viewpoint of an advisor or investor, especially considering where rates have been the past 10 years, we think it is very important to recognize the value of current rates on tax-exempt debt. While there may be challenges in supply and demand, the market is full of bonds with solid credit ratings and extremely competitive yields on a tax-equivalent basis.
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