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October 2022

Tax-Exempt Strategies: Michael Taila and William D. Black Q3 2022






Key Points

  • Higher rates bring bilateral focus to the market
  • Investment opportunities surface amid volatility
  • Emphasis on issuer and sector selectivity

Municipal bonds confronted an unsettled market during 3Q2022 as a continuation of aggressive monetary policy and a lack of clarity surrounding the economic trajectory gained prominence. A determined Fed will likely expose the broader financial markets to additional interest rate pressure as inflation risk lingers. The back-to-back rate hikes in July and September jolted yields higher in shorter Treasury maturities, with municipals moving in sympathy.

While more subtle shifts occurred further along the curve, the price declines led municipal bond yields towards levels not seen in at least a decade. On the one hand, market participants naturally acknowledge performance challenges YTD. However, investment grade (IG) and high yield municipal (HYM) investors can acquire attractive tax-exempt income at a lower cost. As we enter the year’s final stretch, liquidity mandates continue offering a competitive advantage while portfolios with more maturity flexibility (e.g., HYM and intermediate strategies) can unlock value across the curve.

The old financial market adage “let volatility be your friend” is an appropriate tactic as opportunities arise out of dislocation. Despite the inconsistent behavior of the municipal bond market this year, staying engaged and capitalizing on periods of weakness can significantly improve portfolio risk/reward outcomes. For example, the AAA benchmark yield curve experienced an upward move of approximately 220 bps to 300 bps YTD. Conversely, the yield-to-worst on the Bloomberg HYM index ended the quarter at 6%-the highest level in at least five years. Technical indicators, such as municipal fund flows, influence the market’s direction. According to Lipper, municipal funds experienced more than $90 billion in redemptions YTD. While these large outflows contribute to price volatility, in some cases, bond valuations improve buying opportunities that may enhance forward-looking return potential and income generation.

As the market digests the potential for an economic slowdown, municipal investors will likely scrutinize the credit quality of IG and HYM issuers. We believe careful security selection and sector positioning will contribute significantly to portfolio resiliency and performance. Direct and indirect federal pandemic aid and strong revenue performance over the past two fiscal years have benefited many IG and HYM issuers. Healthy balance sheets and ample enterprise resources reasonably position many issuers to absorb near-term headwinds from high inflation and economic weakening. Nevertheless, we will continue to monitor credit trends and identify those issuers with a long-term focus on budget balance, as quality is seemingly at a peak for the cycle.

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