Q2 2023 Putnam Muni Bond Funds Q&A
- Although the Federal Reserve did not hike rates in June, markets priced in additional Fed hikes during the quarter overall.
- The funds have overweight exposure to both the lower tiers of the investment-grade universe and the highest-rated portions of the high-yield universe.
- We believe municipal bonds represent a high-quality diversification strategy at this point in the economic cycle.
How did municipal bonds perform during the second quarter of 2023?
The quarter was a tale of two halves. Municipal bonds encountered headwinds in April and May, along with other fixed income assets. Lingering concerns about the failure of a few regional banks in March 2023, the U.S. debt ceiling, and higher U.S. Treasury rates weighed on investor sentiment. From a technical perspective, anemic flows into municipal bond mutual funds combined with the FDIC’s liquidation of municipal bond holdings from failed banks weighed on the asset class.
At its May 2023 meeting, the Federal Reserve raised its benchmark interest rate by 0.25% to a range of 5.00%–5.25%. In its commentary, the Fed suggested that future interest-rate hikes would be dependent on the effect of past rate hikes on the economy. In late May, Congress and the White House agreed to a debt ceiling deal.
In the final weeks of the quarter, sentiment improved. A cooler-than-expected inflation reading for May 2023 led to expectations that the Fed might hold off raising interest rates at its meeting in June. At that meeting, the Fed skipped an interest-rate hike to allow time to assess the effects of its monetary policy and to potentially avoid tipping the U.S. economy into a recession. Fed policymakers added that while two more interest-rate hikes were still a possibility this year, they had not decided whether to keep raising interest rates.
For the three months ended June 30, 2023, the Bloomberg Municipal Bond Index returned –0.10%, outperforming the broader U.S. fixed income markets. The Bloomberg U.S. Aggregate Bond Index returned –0.84%. Long-term municipal bonds outperformed their intermediate- and short-term cohorts. From a credit perspective, high-yield bonds outperformed investment-grade bonds during the quarter, causing a headwind to our portfolio positioning.
What is your current assessment of the health of the municipal bond market?
Municipal credit fundamentals continue to be stable, in our view. Higher employment and increasing wages have bolstered tax receipts in the past few years. We continue to monitor the housing market, including home values, an important factor in property tax revenues.
State and local tax collections fell 4.2% in Q1 2023 compared with Q1 2022. At the same time, total tax revenues are nearly 30% above 2019 levels. Also, state and local governments’ rainy day funds and financial reserves remain elevated at close to 30-year highs. Municipal defaults through June are down nearly 50% versus the average of the past four years and continue to represent a very small percentage of the market. As such, we believe the credit outlook remains favorable, though we continue to actively monitor credit conditions. Security and sector selection remain a cornerstone of our investment process.
As we head into the second half of 2023, we expect economic growth to continue to slow as the economy responds to the last 15 months of higher, Fed-driven, short-term interest rates.
How were the funds positioned at the end of the second quarter?
We continued to have a bias for higher-rated investments throughout the period. The funds generally have overweight exposure to both the lower tiers of the investment-grade universe and the highest-rated portions of the high-yield universe. We remain cautious on lower-rated municipal bonds in general, given our view that the Fed’s aggressive tightening cycle could result in slower U.S. economic growth later this year.
The funds were invested in a wide range of sectors, including charter school, retirement community, private higher education, housing bonds, essential service utilities, and state-backed bonds. We targeted a modestly long-duration position in the portfolios relative to their Lipper peer groups. [Duration is a measure of the funds’ interest-rate sensitivity.]
What do you see on the horizon that could influence your management of the funds?
Interest-rate volatility, a hawkish Fed, and inflationary pressures could remain headwinds for rate-sensitive investments in the near term, in our view. However, we believe we are close to the end of the Fed’s tightening cycle. Accordingly, we regard any market volatility as an investment opportunity and continue to be vigilant for dips in the market that can present attractive entry points. Current valuations remain attractive as taxable equivalent yields are near 6%, which is relatively cheap on a long-term basis.
We believe municipal bonds represent a high-quality diversification strategy at this point in the economic cycle. We continue to take the long view that credit fundamentals are sound, defaults remain below average, and valuations have cheapened.
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