Municipals rally as U.S. inflation slows

Municipals rally as U.S. inflation slows

Q4 2022 Putnam Muni Bond Funds Q&A

  • With the inflation outlook improving, municipal bonds turned in their first quarter of positive performance for calendar 2022.
  • We remain cautious on lower-rated municipal bonds due to our view that the Fed’s aggressive tightening cycle could result in slower U.S. economic growth in 2023.
  • Seasonal factors are typically constructive for the municipal bond market in the winter months, and credit fundamentals are sound, in our view.

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

Municipal bonds turned in their first quarter of positive performance in calendar 2022. November was especially strong for the asset class, despite the Federal Reserve’s announcement of its fourth consecutive 0.75% interest-rate increase on November 3. Investors were heartened to see that the inflation rate for October 2022 came in weaker than expected. The Consumer Price Index [CPI] fell to 7.7% from 8.2% in September 2022. Investors interpreted this as evidence that the Fed was making progress in subduing stubbornly high prices. As the month ended, the Fed hinted it might temper the degree of interest-rate hikes as early as December 2022.

The CPI for November came in better than expected, with year-over-year inflation falling to 7.1%. It was the smallest 12-month increase since December 2021. In our view, this gave the Fed room to raise its benchmark interest rate by only half a percentage point on December 15, 2022. However, Fed policymakers also signaled the fight against inflation was not over. Fed Chair Jerome Powell stated that “it will take substantially more evidence to give confidence that inflation is on a sustained downward path.”

Market technicals improved during the quarter as well. New-issue supply was very light, aiding returns. In fact, new issuance in November and December 2022 fell 30% and 58%, respectively. Furthermore, December 2022’s level of new issuance represented the lowest level of issuance since December 2000. At the same time, demand rebounded amid the improvement in investor sentiment. November saw municipal bond fund inflows for three weeks, reversing the trend of historic outflows in 2022.

With all these positive developments, November’s return of 4.68% represented the strongest monthly return for the Bloomberg Municipal Bond Index since 1986. For the three months ended December 31, 2022, the benchmark returned 4.10%, outperforming U.S. Treasuries and the broader fixed income markets, as measured by the Bloomberg U.S. Aggregate Bond Index. Long-term municipal bonds slightly outperformed their intermediate- and short-term cohorts amid the rally. From a credit perspective, investment-grade municipal bonds held up better than higher-yielding, lower-rated bonds, which aided our positioning across Putnam’s municipal bond fund complex.

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. Home values, a factor in property tax revenues, are facing headwinds in the form of rising mortgage rates. We believe assessed values, another factor in taxes, should continue to reflect growth given the roughly two-year lag between tax assessments and actual property values.

State and local tax collections were up 13.4% year over year through September 2022 compared with the same period in 2021. Unprecedented fiscal support during the Covid–19 pandemic, as well as strong economic growth during the second half of 2020 and 2021, put most state and local governments in their best fiscal shape in more than a decade, in our view. Although we believe pension funding will likely fall in 2022 due to capital market returns, most large public pensions entered 2022 in their best fiscal shape in over 10 years. Finally, municipal defaults are running near long-term averages year to date through December 31, 2022, and they remain a very small percentage of the market. As such, we believe the credit outlook remains favorable.

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

At quarter-end, the funds held an overweight exposure to lower-investment-grade bonds and those rated BB relative to the benchmark. 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 in 2023. However, we have found value in some of the upper tiers of the high-yield market. While credit spreads widened over the period, they were not excessively wide versus previous recessionary periods, in our view.

The funds were invested in a wide range of sectors, including charter schools, retirement communities, general obligation, and higher education bonds, as well as some housing-related credits. Duration positioning, a measure of the funds’ interest-rate sensitivity, was slightly long relative to the average level of their Lipper peer groups. We believe this positioning may help the funds outperform their peers if the steep rise in bond yields reverses course.

The funds remained underweight in their exposure to Puerto Rico municipal debt relative to their Lipper peer groups. However, we note that the U.S. territory has experienced recent improvement in credit fundamentals. In March 2022, Puerto Rico came out of bankruptcy after nearly five years with a plan to restructure its debt, resume payments to bondholders, and restore its public pension system. We continue to closely monitor Puerto Rico’s credit fundamentals and remain vigilant for investment opportunities.

What is your outlook as we enter 2023?

Although it appears to us that inflation has peaked in this cycle, we believe U.S. economic data remains relatively strong. Especially noteworthy is the low U.S. unemployment rate and strong consumer spending. We presume this will keep the Fed on track to continue ratcheting up interest rates to slow economic growth and the jobs market. That said, we think the bulk of the tightening is behind us and Fed monetary policy is set to enter the fine-tuning stage of the cycle. Market expectations are for the Fed to complete its tightening cycle by the spring of 2023.

Seasonal factors are typically constructive for the municipal bond market in the winter months, and credit fundamentals are sound, in our view. We believe the income and tax advantages provided by municipal bonds continue to offer shareholders a valuable way to diversify their overall portfolio.

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