2022 has been a painful year for muni investors. But now that yields are higher, there are reasons for investors to take heart—and take action.
When you think about the historic period we’ve just been through and what normally happens across financial markets following such a period of volatility, returns are usually pretty good, and that’s certainly the case for municipal bonds right now.
First of all, we know municipal bonds are cheap. The additional yield from a municipal bond is a multiple of what it was running prior to the pandemic. We know the fundamentals are strong. Rainy day funds—reserves that states have in place to weather a potential downturn in the economy—approach 120 billion dollars. As a percentage of spending, roughly three times what it was before the great recession.
We also know the Fed is very committed to fighting inflation, but we don’t know how long that process is going to take. We know along the way we earn much higher coupon, much higher yield than we’ve earned in a long time, and we know that once they do stop the tightening cycle and rates do stabilize, there’s a process that historically follows that results in the normalization of municipals and outsized returns.
What if the Fed continues to hike aggressively?
If we assume the Fed is still hiking, that means there have not been confirmed signs that inflation has been beaten. It means the market is still trying to interpret the economic data and handicap when the Fed is going to stop, which means there will be volatility, which, for an active manager, means opportunities. There will be dislocations, bond prices will be moving around, if you’re an active manager you can take advantage of it. So that’s the short term.
Longer term, the market has really priced in what we think is the ultimate rate for fed funds. Spring of next year, four-and-a-half percent, we don’t think it goes that much higher, which as a result means at the end of the day, yields for longer-term bonds really shouldn’t go that much higher.
What if there’s a recession?
When we bring up a recession scenario, it’s important to underscore the role of municipal bonds, and bonds in general, in your asset allocation. They serve to offset the risk you’re taking elsewhere in your portfolio, and if you look at how conservative bonds have done during recessionary environments, going all the way back to the ’60s, they generate good returns. And municipals do particularly well because of their underlying strong credit quality.
Defaults, rating migrations, really don’t even register compared to what you see in the corporate bond markets.
Thinking about your portfolio over the next year, year and a half, it’s really important to position it to take advantage of the opportunities in today’s market. To take advantage of opportunities that should enable you to recover some of the historic drawdown that we’ve just had.
That means if you own Treasuries, to some extent, recently to diversify, you should reduce those holdings. Municipal bonds are cheap; you want to take advantage.
Within the municipal market you want to own the bonds that represent the most value. Those are credit-oriented bonds, single As, triple Bs, even a little bit of municipal high yield.
How do you approach tax-loss harvesting?
Tax-loss harvesting is always an important, valuable part of bond management. In our view, it should be pursued throughout the year as there are opportunities. For investors who have not realized losses for tax purposes this year, now is still a good time to do it. It’s a good time to do it and take advantage of improving your portfolio at the same time.
So if you own nothing but double A, triple A municipals, it’s a great time to realize those losses and shift a portion of the portfolio into the area that’s attractively priced that should have better returns going forward.
We’re starting right now with the yield, in many cases, three times what it was at the beginning of the year for a comparable strategy. There are dislocations within the markets. Credit spreads are wider. That means there’s opportunity to supplement the yield with total-return opportunities in ways we haven’t seen in years.
So it’s been a very painful year, but when you think about where return comes from in bonds, we’re much better positioned going forward both for returns and also to serve the role of diversification in your overall portfolio.