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April 2022

First Quarter Challenges to Municipals May Fade Away

Monetary policy and geopolitical developments driving sentiment


Market dislocation creates value opportunities for investors


Issuer credit quality remains durable

Market volatility left no stone unturned as broad asset class weakness led to lower prices and challenging performance during the first quarter. The Fed began its highly anticipated rate-tightening campaign to rein in accelerating inflation whilerising global risks contributed to the noticeable backup of yields across fixed-income markets.

As investors reassess the market trajectory, treasuries and municipals will likely ebb and flow in response to monetary and fiscal policy changes and expectations for the sustainability of the current economic expansion. Despite a difficult start to 2022, we see potential catalysts on the horizon for long term investors to engage the municipal market as nominal yields and bond valuations of investment-grade (IG) and high-yield municipals (HYM) advance to levels not seen since at least 2020.

IG and HYM bond yields increased more than 100 bps across the curve throughout 1Q2022, with credit spreads widening moderately amid the most significant cumulative market outflow activity since 2020. With added selling pressure from seasonal tax payments (i.e., tax-loss swaps), the market is confronting a price discovery period, offering investors an opportunity to upgrade credit quality and structure (e.g., coupon) while booking more attractive yields. Going forward, market volatility and liquidity challenges may very well create investment headwinds. However, if municipal pricing breaks away from the Treasury market as a more attractive technical environment takes hold, we could see an improved tone with perhaps extended outperformance. Additional downside risks could develop over the near term as the market digests Fed lift-off and geopolitical implications, particularly the Eastern Europe crisis.

Against this backdrop, the credit quality of IG and HYM bonds is benefiting from continued economic growth and more robust revenue performance vis-à-vis budgetary surpluses. State and local governments and municipal enterprises are further enjoying the availability of federal resources from the American Rescue Plan Act of 2021, among other stimulus programs. Rating activity skews positively while stress indicators remain low across most market sectors. We continue to monitor the impact of inflation on revenue risk and costs for issuers but expect financial positions to absorb the near term effects.

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