U.S. Treasury yields, which hold great influence over investment grade municipal bond yields, have risen sharply this year. For example, since the beginning of 2022, the 5-year U.S. Treasury yield has increased by 152 basis points (1.52%) to almost 2.8%, fueled higher by extreme Fed policy hawkishness and white-hot inflation. 5-year AAA tax-exempt muni yields have increased by 187 basis points (1.87%) to just under 2.5%.
Among shorter-dated securities, the relative performance is more uniform between these sectors, indicative of the overwhelming influence of Fed policy expectations among most fixed income sectors. However, several underlying factors support our view that investment grade munis are poised for relative near-term outperformance and offer a compelling case for new investment.
Absolute yields – Munis have followed U.S. Treasuries’ lead to higher absolute levels across the curve. Similar to our view of U.S. Treasury yields, shorter-dated (1-7 years) investment grade munis offer a compelling mix of moderate interest rate exposure and the highest yields in more than a decade (excluding their very brief spike in early 2020).
Muni-to-U.S. Treasury ratios – Elevated volatility, lower relative liquidity, and forced muni mutual fund selling have recalibrated muni-to-U.S. Treasury ratios from very rich levels to a far more attractive relationship.
Relative value – In many parts of the curve, tax-equivalent yields for AA and A-rated munis exceed like-rated corporate debt, despite munis offering less defaults and better insulation from economic slowdowns.
Fundamentals – Muni issuers’ reserves and tax receipts are exceptionally strong, further aided by massive federal stimulus. Additionally, muni issuers tend to benefit from inflation, which increases sales and property taxes. Investment grade default rates remain very low.
Technicals – The municipal bond market is entering a more favorable seasonal period, where demand typically rises post-April 15th. New supply remains constrained by below-average new issuance and slower debt refinancing. Historical performance tends to improve following periods of strong outflows like we have witnessed over the previous 10 weeks.
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