With an economy in recovery and inflation at its highest level in decades, the Federal Reserve has signaled it will soon begin increasing short-term rates. Fed Chair Jay Powell indicated the Fed may announce the first hike at its March 16, 2022, meeting.
Below, we review the four most recent rate-tightening cycles to glean insights for a municipal bond strategy.
All Fed cycles are not equal
The table shows annualized returns of the investment-grade municipal index and muni bonds of different maturities over periods of rising interest rates. No two cycles were the same.
Annualized total returns
Sources: Bloomberg Finance L.P., J.P. Morgan 2021.
Yield changes (bps)
HG represents high grade or investment grade.
Sources: Bloomberg Finance L.P., J.P. Morgan 2021.
Analyzing the last four cycles, we observe some general outcomes about muni performance.
- Muni yields move higher, especially near the front end of the yield curve. On average, yields on 2-year munis rose +138 bps while 10-year munis rose +58 bps and 30-year munis rose 40 bps
- The muni yield curve flattens. Short -duration muni yields rose more than long muni yields as the Fed increased the federal funds rate
- The federal funds rate rose an average +250 bps in the four tightening cycles
- The longest duration assets had the largest negative returns in accelerated Fed cycles, when rates increased more than the market was expecting (in 1994 and 1999)
Compare current long muni yields with expectations of the ending fed funds rate
When longer term muni rates begin a Fed cycle at or near the expected ending federal funds rate, returns are generally higher. This is not the case when the federal funds rate rises above market expectations.
In the June ’04 to June ’06 cycle, the FOMC increased the federal funds rate to 5.25%, which was near the 30-year muni yield when the tightening cycle began (5.02%). The muni index returned more than 4% (annualized) in that period.
The most recent Fed tightening cycle was from December 2015 to December 2018. In December 2015, the market expected the cycle to end when the fed funds rate reached 3.50%. The rate peaked at 3.00% in 2018. The Fed increased the rate less than the market was expecting. Muni index returns averaged 2.3% in that period.
Many factors influence performance
Muni returns do not suggest to us at this time that investors should avoid duration risk. Other factors besides duration influence performance, including yields at the start of the cycle, yield curve placement, and active strategies.
Munis are not immune to volatility
Muni index returns were -2.7% in January 2022 as stocks fell and Treasury bond yields rose. It was the fourth-weakest month for the muni index in the past 10 years. Muni valuations relative to Treasuries, which were stretched in 2021, started to look attractive. Credit spread widening during early 2022 has also created value in some cohorts, in our opinion.
Still, volatility is likely to remain elevated as the Fed begins raising rates. Muni funds industry-wide recently turned to outflows. Our team of analysts closely monitors market conditions.
Valuations may create an entry point
Current valuations may create an entry point for a long-term muni allocation. The following chart shows that from 2012-2022, munis had positive returns in more than half of the months.
Monthly muni index returns (%), 2012 to 2022
Sources: Barclays, Putnam 2022.
Credit quality is solid
Unprecedented fiscal support, tax revenue outperformance, and strong economic growth expectations have put most state and local governments in the best fiscal shape for more than a decade. State and local tax collections were up 13% through Q3 2021 compared with 2020.
Tax hikes implemented in 2020 have propelled year-to-date tax collections in certain states. For example, New York saw a 50% jump in year-over-year revenue, and New Jersey posted a 24% increase, well above the national average.
Many states are maxing out their rainy-day (reserve) funds. For example, Massachusetts added $1.1 billion to its rainy-day fund in FY21. California is likely to see an estimated $26 billion surplus by the end of its 2022 fiscal year in June.
Many muni sectors benefit from well-funded states. These sectors include cities and counties, school districts, charter schools, housing, and public universities. Higher home prices should support cities and school districts as tax assessments catch up to real values.
In the education sector, significant endowment returns in FY 2021 (33% year-over-year on average, ending 6/30/21) will support non-profit and university balance sheets.
Municipal defaults are in line with long-term averages. Defaults remain isolated in the lowest rated cohorts.
State and local government pensions are in their best fiscal shape in more than 10 years (PEW Research, 2021). More than 80% are funded. This improvement is driven by asset performance plus a trend of more conservative accounting assumptions used by states and cities.
Another tailwind is federal aid and infrastructure spending, which should reduce the need for state debt issuance for capital projects. New-money debt issuance in calendar-year 2021 was at its lowest level since 2017.
An active approach
Markets are pricing in five rate hikes by the FOMC in 2022, which is higher than our economists expect. While volatility will likely continue, the muni market offers strong credit quality in many cohorts. The economic recovery remains a tailwind for muni credit, barring continued volatility shocks.
Our experienced team of municipal portfolio managers, credit research analysts, and traders work together to analyze securities and construct portfolios. In our view, the muni market is sound and can serve investors seeking tax-exempt income in a high-quality, low-default asset class.
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