Municipal bonds have witnessed a record number of outflows this year, but many experts in the market say there is little reason to be alarmed. Some expect a significant comeback later this summer as interest rates stabilize. Others, meanwhile, are interested but not ready yet to invest in the market.

This tax-free sector have enjoyed tremendous popularity with individual investors in the past but this year has seen significant disruption in the face of rising interest rates. Through an 18-week stretch the market suffered record-setting outflows of more than $68 billion. Coupled with a decline in the amount of inflows, some are wondering if municipal bonds will continue to be the reliable investment many income-oriented investors have considered them to be. 

Few areas of the fixed-income market, including munis, have been spared in 2022, which some have estimated to be the worst year for bonds so far since 1842. “It’s been a horrible and painful year for all [fixed-income] managers,” said Catherine Stienstra, head of municipal investments at Columbia Threadneedle.

While selloffs are fairly common for these offerings around this time of year, Stienstra said the industry has never experienced such a sharp downdraft before. There are several factors that led to this including rising interest rates initiated by the Federal Reserve, putting pressure on all fixed-rate products across the board.

Sean Carney, head of municipal strategy at BlackRock, is reasonably optimistic. He believes there is no reason to expect that the municipal securities won't remain a viable investment.

 

In the short-term, many states are flush with cash thanks to stimulus checks from the federal government. Beyond that Carney said most have been fiscally responsible by managing their budgets and controlling spending. With this year being an election year, most will not be tempted to make many dramatic changes to their states. “The worst of these moves is behind us now,” Carney said.

 

Stienstra agreed saying that even though the influx of federal cash is only a temporary adjustment, the positions of the local and state governments continue to show positive signs for the future and the health of the municipal bonds. “Across the local and state credit markets, we feel very good about it,” she said.

In the face of this adversity, some advisors have not lost faith in the offerings and continue to use them in client portfolios. “We’re using municipal bonds a lot and leaning into them even more,” said Chad Carlson, president and chief investment officer at Balasa Dinverno Foltz in Itasca, Ill.

Carlson added that while the start of the year was difficult, he is optimistic that municipal bonds will make a full recovery. In fact, some think that signs of that turnaround are already manifesting themselves.

In recent weeks, the industry has seen those record-breaking outflows greatly slow while the level of inflows has remained constant. The Bloomberg Municipal Bond Index was down by more than 10.6% on May 18 and by June 8, it had fallen only 7.6%. 

Despite the volatility, municipal securities continue to offer a safe environment for those investors who are looking to get back into bonds, but do not want to take a lot of risk, according to Carney. “When people are looking to put their money back to work in a high-quality fixed income product over an overly risky option, municipal bonds fit that bill,” he said.

 

Several factors give municipal bond managers confidence in this turnaround. First, the Federal Reserve has made its intentions regarding raising interest rates over its next few meetings clear, giving the market some clarity, Stienstra said.

 

Another area of uncertainty pertains to tax season, as some investors cashed out of their municipal bonds to pay for their taxes. However, much like the Fed’s decision, the tax concerns are in the past.

A major shift in the municipal market traditionally takes place over the next few months. It is a time many refer to as a net negative period when municipal bonds and coupons start to mature and investors sell them off, according to Carney.

Subsequently, investors will look to reinvest into these offerings and while the demand will be high, states and local municipalities do not tend to issue as many bonds, which increases demand and then drives the prices up. Payments outpace new brands during this period.

This will result in a more positive performance of municipal bonds which will eventually lead to strong inflows. “Performance will turn first,” Carney said. “Then on a lag, flows will increase.”

Municipal bonds tend to be a favored investment for those who are looking for a safe investment option. The funds are also tax-free, which is another positive for them. 

Not everyone is ready to jump back into the municipal bond pool just yet. Andy Kapyrin, co-chief investment officer at Regent Atlantic, said that they are actively steering clients away from municipal offerings for the time being.

“I think municipal bonds are a good investment,” he said. “They are just a little rich right now.”

He pointed out that traditionally the offerings are geared more for clients of the highest tax bracket, which means that they have to make sense from a tax standpoint for them to be a viable investment for clients. To start recommending the offerings to clients again, Kapyrin said he would need to see the after-tax spread between tax-exempt offerings and corporate bonds begin to narrow.

Stienstra and Carney, meanwhile said that signs are appearing that demonstrate that the market has not lost faith in the offerings. Stienstra said that they are starting to see more cross-over buyers in the market. 

For the rest of the year, we feel very good about the fundamentals of our market," she says. "Even sectors that were underforming during the pandemic are starting to recover."

Traditional municipal bond investors tend to be the retail investors. However, Columbia Threadneedle has seen an increase in investments from non-retail investors such as banks, insurers, taxable mutual funds, and even hedge funds. In the past, the sign that these non-traditional investors were putting their money into municipal funds was an indication that they were leading the way for the traditional investors to return. 

“Valuation [concerns] are overdone and municipal bonds offer a great [opportunity for investors],” Stienstra said. “Because of the dramatic selloffs, we expect many of the traditional investors to return.”

Kapyrin said that he sees a different perspective on the offerings. He believes that the tax benefits of municipal offerings are not as attractive as they once were.

He attributes the decline in attractiveness with the offerings to the Tax Cuts and Jobs Act of 2017 signed by former President Donald Trump. Among the many taxes the law reduced was the corporate tax rate. When that occurred, the reduced tax rate for corporations made the municipal offerings less attractive on a relative basis than investment funds sporting higher yields.

That doesn't mean the market will not come back. In fact, Kapyrin believes that they are still strong offerings given their tax-free nature and the fact that they are issued by local and state governments, which stand minimal chances of defaulting.

“For the first time ever, we have seen a really tough quarter and the perception of risk on these offerings has changed,” he said. “Investors have to come to terms with this new perception.”