The optimism Wall Street has for municipal bonds this year remains intact, even if the promise of higher interest rates is hitting munis almost as hard as other markets.
“There are aspects that are unique to the muni market and just looking at those, it’s poised to be a pretty good year,” said Daniel Solender, head of municipals at Lord Abbett & Co. “The economy is doing well, a lot of balance sheets are flush with cash from the stimulus. The true wild card is what is going to happen with rates.”
The $4 trillion municipal market is likely to benefit from a continued bounty of new bond sales and a strong credit environment, with states and localities bolstered by tax revenues and pandemic-era federal aid, a review of annual outlooks and interviews with analysts and investors at more than a dozen firms show.
The forecast for investor demand is less robust, with the Federal Reserve poised to raise rates to combat the fastest inflation in almost 40 years and U.S. tax increases less likely than anticipated last year. So far this year, tax-exempt municipal bonds have lost about 1.3%, after gaining 1.5% for all of 2021, and they are on track to post the worst monthly performance since February, according to Bloomberg’s benchmark index.
While January’s muni return isn’t all that attractive, it beats those of U.S. Treasury securities and investment-grade corporate debt, which have dropped 1.95% and 2.8% respectively, according to Bloomberg indexes.
“It’s likely that muni bonds won’t perform as well as they used to, but I don’t expect it to be a massively awful year,” said Cooper Howard, director of fixed income strategy at the Schwab Center for Financial Research.
A troubling sign is a recent drop in demand. Muni mutual funds saw $239 million withdrawn during the week ended Wednesday, halting a streak of 45 straight weeks of gains, according to Refinitiv Lipper US Fund Flows data. Municipal bond funds had a record amount of inflows in 2021, helped by anticipation of higher taxes from the Biden administration’s spending plans, some of which are now stalled in Congress.
“The likelihood that demand weakens is higher in 2022 than it was in 2021,” wrote Adam Stern, co-head of research at Breckinridge Capital Advisors in an outlook note published earlier this month.
In another signal of waning investor interest, about $1.4 billion of municipal bonds were being offered for bids from potential buyers on Thursday, the most since April 2020, according to a Bloomberg index.
“Treasuries are really in the driver’s seat,” Paul Malloy, head of municipals at Vanguard Group, said in an interview. “While fundamentals are really good, we expect munis to move alongside Treasuries.”
Still, most market professionals aren’t calling for a major retreat from the asset class.
“We believe that investors’ appetite toward munis will continue in 2022; however, should tax rates be lower than current expectation, there could be a mild pullback in demand,” according to Brian Rehling, Peter Wilson and Luis Alvarado at Wells Fargo Investment Institute, in a Jan. 18 strategy note. They have a “favorable” view of municipal bonds, saying that rising rate cycles by the Fed have historically been positive for the market.