Some economists predict a reduction in muni demand this year due to a predicted slowing in household savings, which grew during the pandemic, particularly among the wealthy. The demand for tax-exempt debt has long outstripped annual issuance.
Is it wise to invest in municipal bonds in 2022?
The key drivers of the municipal market are all positive, therefore 2022 is expected to see ongoing robust demand for municipal bonds. Taxes are first and foremost. Investors are still concerned about increasing taxes and will do everything possible to avoid them, keeping demand high.
Is now a good time to invest in municipal bond funds?
Municipal bonds have attracted a lot of money from investors looking to decrease risk and taxes. Some investors may be concerned about price drops as the Federal Reserve seeks to raise interest rates. However, muni bonds may see higher coupon rates, and a well-constructed portfolio can still meet long-term objectives, according to financial experts.
Why are the prices of bond funds falling?
- Bonds are generally advertised as being less risky than stocks, which they are for the most part, but that doesn’t mean you can’t lose money if you purchase them.
- When interest rates rise, the issuer experiences a negative credit event, or market liquidity dries up, bond prices fall.
- Bond gains can also be eroded by inflation, taxes, and regulatory changes.
- Bond mutual funds can help diversify a portfolio, but they have their own set of risks, costs, and issues.
How are municipal bonds faring?
In terms of performance, new issuance, and investor demand, the municipal bond market had a strong year. This achievement is all the more remarkable given that it occurred at a time when inflation was rising, interest rates were rising, and the epidemic was still going strong.
On the technical side, new issuance increased by about 15% in 2021, reaching a new high of $316 billion. Furthermore, fund flows were positive in 51 of 52 weeks, reaching more than $100 billion, a new high. As a result, the supply of fresh issues was rapidly consumed, and oversubscriptions were common.
Since mid-2020, the fundamental credit quality of municipalities has been improving. Municipal issuers, such as state and local governments, airports, public transit systems, hospitals, and schools, received $1.25 trillion in the four key stimulus acts. Furthermore, state government revenues have more than recovered, increasing by 21% and coming in 19% higher than pre-pandemic levels. Only 30 downgrades were given by Moody’s in the third quarter, compared to 115 upgrades.
In comparison to other fixed income asset classes, high quality municipals performed consistently in 2021, with minimal volatility and less interest rate sensitivity. Munis have only displayed 32% of the volatility of US Treasury bonds in the 30-year area of the yield curve, and only 22% in the 5-year segment. For the year, the S&P Main Index (AA-range average credit quality) returned 1.77 percent.
Credit spreads narrowed by 80 basis points over the equivalent-maturity AAA bond this year, from 265 to 185 basis points. This resulted in high yield outperforming investment grade by a significant margin. In 2021, the S&P Municipal High Yield Index returned 6.82 percent, outperforming the market by more than 500 basis points. BBB spreads fell from 108 basis points to 63 basis points in 2021, indicating a narrowing of lower investment grade spreads.
Municipal-to-Treasury yield ratios are still low by historical standards. The 10-year municipal-to-Treasury yield ratio started the year at 76 percent, matching its historical average, but fell to 68 percent at year’s conclusion. Although this is a long way from its tightest levels in 2021, it still demonstrates the asset class’s resilience in this portion of the curve. 30-year ratios, which are normally less expensive than 10-year ratios, fell to 78 percent at the end of the year, compared to a long-term average of 93 percent.
The supply of new issues fell marginally from 2020 to $358 billion, but the composition was very different. Refinancings fell by 24 percent, but new capital issuance increased by approximately 15 percent to $316 billion.
Taxable municipal supply fell by 20% for the year, but it is still a far larger part of the total market than it was before the Tax Cuts and Jobs Act of 2017. Taxable munis accounted for 30% of the new issue market, with over $140 billion in new issuance.
In terms of fresh issuance in 2022, there is a lot of uncertainty. For both tax-exempt and taxable municipal borrowers, interest rates and spreads are now attractive. If rates rise rapidly, though, this attractiveness will alter. Furthermore, because state and local governments are flush with federal stimulus funds and record revenue receipts, projects might be funded without incurring new debt. Rising rates, on the other hand, may not deter issuance because infrastructure improvements need significant money, and increased revenues provide borrowers confidence to take on new debt.
Forecasts for new issuance in 2022 range from $400 billion to $520 billion, with a median of $470 billion. Moderate growth from last year’s level appears to be the most likely scenario.
In 2021, municipal mutual fund flows were constantly positive, with investor demand increasing 51 times out of 52 weeks. In October, November, and December, open-end mutual funds received $1.94 billion, $4.84 billion, and $2.34 billion, respectively. The annual total was roughly $71 billion through November. Municipal exchange-traded funds increased at a quicker rate than mutual funds on a percentage basis, hence this total understates interest in the asset class.
In October, November, and December, high yield municipal fund flows were -$264,000, +$2.60 million, and +$2.28 million, respectively. Annual fund flows were also strong in November, totaling roughly $20 billion.
Payment defaults totaled $2.1 billion in 2021, down 19 percent from the previous year. This is still a relatively modest portion of the $4 trillion market. Nursing homes and revenue bonds for industrial development continue to account for over 75% of all municipal defaults in 2021. Prior to the pandemic, these groups contained among of the most idiosyncratic risks in the municipal market, and they accounted for a large share of overall new defaults. In most cases, the defaults cannot be explicitly linked to pandemic consequences, however this may change in the future. We do not believe that municipal payment defaults will become prevalent.
Outlook
The municipal bond market, like the rest of fixed income, is facing headwinds. With a tighter labor market and stubborn inflation, the Fed may be able to accelerate the end of QE and start raising rates sooner than expected. Furthermore, fiscal stimulus should be reduced drastically.
- The US economy is doing well on its own, which means less monetary and fiscal assistance is required. The federal deficit in the United States has been drastically reduced as a result of this normalization process compared to the previous year.
- Municipal cash and revenue levels are at all-time highs, with credit trends in most sectors going in the right direction.
- Demand for both taxable and tax-exempt municipals is outstripping new supply, indicating that liquidity is strong.
- Potential new federal government initiatives that could have an impact on the municipal market have seen a significant decrease in volatility.
Overall, we think it’s a good idea to take advantage of the upward momentum in municipal credit, which has had little association with Treasury rate movements. We would see this as a chance to buy into weakness and higher yields if Treasury market volatility has a negative influence on municipals at key periods this year.
- Although the Federal Reserve is focused on controlling inflation, the course of inflation will be a wild card in 2022.
- The Federal Reserve has expedited the pace of tapering in order to end it earlier in 2022, and it has hinted at a first rate hike as early as March. This year, there could be as many as four rate hikes, with more hikes predicted until 2024.
- Although the economy has reached its peak, growth remains strong as the economy returns to normalcy.
- The $1.2 trillion Infrastructure Bill was passed in late 2021 with some cuts. More fiscal stimulus is possible, although at a far lesser level than in the previous two years.
- The net supply of tax-exempt municipals may be restricted, but demand has easily absorbed supply. The taxable municipal supply is expected to be strong, following the same trajectory as in 2021.
- Municipal credit has rebounded strongly since the downturn, bolstered by greater tax receipts and trillions of dollars in federal assistance.
- COVID-19 and its variants can have an influence on global growth, while outbreaks in the United States are less likely to trigger widespread shutdowns or have a negative impact on municipal credit.
- We predict high yield municipal bonds to continue to outperform in 2022, despite variable interest rates and robust credit conditions.
What is the bond market’s outlook for 2022?
The rate differential between five-year Treasury notes and Treasury Inflation-Protected Securities, or TIPS, is measured by this indicator. This figure is close to the Federal Reserve’s own estimates of 2.6 percent for 2022 and 2.3 percent for the following year.
In 2021, are municipal bonds a decent investment?
- Municipal bond interest is tax-free in the United States, however there may be state or local taxes, or both.
- Be aware that if you receive Social Security, your bond interest will be recognized as income when determining your Social Security taxable amount. This could result in you owing more money.
- Municipal bond interest rates are often lower than corporate bond interest rates. You must decide which deal offers the best genuine return.
- On the bright side, compared to practically any other investment, highly-rated municipal bonds are often relatively safe. The default rate is quite low.
- Interest rate risk exists with any bond. You’ll be stuck with a bad performer if your money is locked up for 10 or 20 years and interest rates climb.
Will bonds be successful in 2022?
If you know interest rates are going up, buying bonds after they go up is a good idea. You buy a 2.8 percent-yielding bond to prevent the -5.2 percent loss. In 2022, the Federal Reserve is expected to raise interest rates three to four times, totaling up to 1%. The Fed, on the other hand, can have a direct impact on these bonds through bond transactions.
Is a Municipal Bond dangerous?
- Municipal bonds are a wonderful option for consumers who want to keep their money while earning tax-free income.
- General obligation bonds are used to quickly raise funds to meet expenses, whereas revenue bonds are used to fund infrastructure projects.
- Both general obligation and revenue bonds are tax-free and low-risk investments, with issuers who are quite likely to repay their loans.
- Municipal bonds are low-risk investments, but they are not risk-free because the issuer may fail to make agreed-upon interest payments or be unable to repay the principal at maturity.
In a recession, do bonds lose value?
This also indicates that the worst of a stock bear market usually happens before the recession’s darkest phase. The majority of bond price gains, as well as the lowest yields, occur prior to and during the worst period of a recession. This was true throughout the 2001 recession, as well as late 2008, when the Great Recession was at its worst. This can also be seen in the current 2020 stock market bad market and recession.