The municipal market was a relative bright spot within the fixed income markets last year despite higher U.S. Treasury yields. Strong investor demand and fewer investment opportunities (due to less debt issuance) provided a tailwind to muni returns. Moreover, improving tax receipts and strong federal support provided additional reasons for the municipal market to outperform Treasury securities during a rising rate environment. And while some of these tailwinds remain (most notably the improved fundamental picture for many state and local governments), performance this year has been roughly in line with taxable markets. That said, and as shown in the table below, municipal markets have tended to outperform Treasuries (as defined by the Bloomberg Treasury Index) during rising rate environments. In fact, since 2004, investment grade munis (as defined by the Bloomberg Municipal Index) have outperformed Treasuries 12 of the last 13 times when the 10-year Treasury yield moved meaningfully higher. The non-investment grade segment of the municipal market (Bloomberg Municipal High Yield Index) has outperformed 11 of the last 13 times as well.
“While no one likes negative returns, the path to higher returns is through higher yields,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “With better fundamentals and improving valuations, future returns could potentially be more attractive.
A silver lining to the negative returns for munis this year is that returns are negative due to price pressures and not because of downgrades and/or defaults. In fact, the fundamental picture for the municipal market remains broadly in good shape and negative returns are due to higher Treasury yields. This is important as the value proposition has improved as yields have increased. So how much have valuations improved? As seen in the LPL Chart of the Day, when looking at the ratio between AAA munis and similar-maturity Treasury yields, a common valuation metric, muni valuations are more in line with five year averages. After remaining in “expensive” territory for much of last year, high grade munis are much more reasonably priced.
We continue to favor municipal bonds as a high-quality option for taxable accounts and still think the high-yield segment could be appropriate for those investors that need additional tax-free income, but are comfortable with the higher risks associated with the high-yield muni market. The fundamental backdrop for many municipalities has improved over the last few years and while we don’t expect as robust investor demand this year, improving valuations make these markets more attractive on a forward-looking basis.
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All index and market data from FactSet and MarketWatch.
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