Fed’s battle with inflation weighs on municipals

Fed’s battle with inflation weighs on municipals

Q3 2022 Putnam Muni Bond Funds Q&A

  • Municipal bonds initially rallied but lost ground due to high inflation and the Fed’s aggressive monetary policy.
  • At quarter-end, the funds held an overweight exposure to bonds rated A, BBB, and BB relative to the benchmark.
  • The increased income from higher yields can help provide a cushion against negative returns and rising interest rates, in our view.

How did municipal bonds perform during the third quarter of 2022?

Municipal bonds started the quarter on solid footing, rallying on expectations that inflation had peaked after reaching a 40-year high of 9.1% in June 2022. Inflation remained a concern, but investors appeared to take comfort that a strong labor market and a relatively healthy consumer might give the Federal Reserve room to temper inflation without provoking a serious recession. At their July meeting, Fed policymakers announced a 0.75% hike in their benchmark interest rate, which was widely expected.

While July’s Consumer Price Index declined to 8.5%, inflation was still running well above the Fed’s target inflation rate of 2%. At the Fed’s annual symposium in Jackson Hole, Wyoming, in late August, Fed Chair Jerome Powell affirmed that any expectation of easing monetary policy was premature.

Municipal bond prices fell and yields rose for the balance of the quarter as the markets priced in more aggressive monetary policy. Investors feared the Fed would announce another three-quarter-point increase in September, or even raise a full percentage point, to demonstrate its resolve in tackling inflation. At that meeting, the Fed approved a 0.75% increase, bringing its target interest rate to a range of 3.00% to 3.25%. In its commentary, the Fed affirmed that ongoing interest-rate increases were appropriate. It also lowered the U.S. growth forecast for 2022, while noting that it continues to see robust job gains.

For the three months ended September 30, 2022, the Bloomberg Municipal Bond Index returned –3.46%. Short-term municipal bonds outperformed their intermediate- and long-term cohorts. From a credit perspective, investment-grade municipal bonds held up better than higher-yielding, lower-rated bonds.

What is your current assessment of the health of the municipal bond market?

Municipal credit fundamentals continue to be strong, in our view. Higher employment, increasing wages, and rising property values have all served to bolster tax receipts. As a result, state and local tax collections were up 18% in the first half of 2022 compared with the same period in 2021. Unprecedented fiscal support during the Covid-19 pandemic and strong economic growth during the second half of 2020 and 2021 also put most state and local governments in their best fiscal shape in more than a decade. Finally, municipal defaults are running below long-term averages year to date through September 30, 2022, and remain isolated to the lowest-rated cohorts. As such, we believe the credit outlook remains favorable.

How were the funds positioned at the end of the third quarter?

At quarter-end, the funds held an overweight exposure to bonds rated A, BBB, and BB relative to the benchmark. The funds were slightly underweight high-yield bonds relative to their Lipper peers at period-end due to our view that the Fed’s aggressive tightening cycle could result in slower U.S. economic growth. We are instead favoring higher-quality investments. Investment-grade securities tend to outperform higher-yielding, lower-rated bonds during economic slowdowns. However, we added risk in bonds rated AA and A, rather than top-tier AAA securities, as well as select credit opportunities. While credit spreads widened over the period, creating attractive buying opportunities, they were not excessively wide versus longer-term averages, in our view.

From a sector- or industry-positioning perspective, we favored charter schools, continuing-care retirement community, and essential-service revenue bonds relative to the funds’ Lipper peer groups. Duration positioning, a measure of the funds’ interest-rate sensitivity, was slightly long relative to the average level of their Lipper peer groups at period-end. We believe this positioning may help the funds outperform if the year-to-date rise in interest rates reverses course.

The funds remained underweight in their exposure to Puerto Rico municipal debt relative to their Lipper peer groups. However, we have become somewhat more optimistic about the U.S. territory’s credit fundamentals. In March 2022, Puerto Rico ended its nearly five-year bankruptcy with a plan to restructure its debt, resume payments to bondholders, and restore its public pension system. We continue to monitor Puerto Rico debt for potential investment opportunities.

What is your outlook as we enter the fourth quarter of 2022?

Municipal bonds are coming off a difficult three quarters. Negative returns, market volatility, and weak supply/demand technicals contributed to record municipal bond fund outflows. However, while we are still cautious, we believe credit fundamentals are strong and valuations are attractive.

Investors will be closely following economic data to parse the Fed’s likely path. In our view, the Fed’s challenge will be calibrating tighter monetary policy to achieve the desired reduction in inflation without creating a recession and excessive job losses. The central bank’s next interest-rate hike is expected in November 2022.

We expect volatility and uncertainty to remain elevated in the near term as stubbornly high inflation, a hawkish Fed, a heightened risk of recession, and the war in Ukraine continue to put pressure on the global landscape. However, the increased income from higher yields can help provide a cushion against negative returns and rising interest rates, in our view. Future returns look more promising for longer-term investors, in our opinion.

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