Thus far in January, investment grade munis and lower rated high yield credits are up by 2.8% and 4.4%, respectively. Despite this rally, yields are still much higher compared to one year ago, broadening the opportunity set for investors who are focused on after-tax income.
We have updated our comparison of AA rated tax-exempt municipal bonds yields to those on US Treasury securities and AA corporate bonds on an after-tax basis to identify the best values along the curve. At present, high grade munis provide attractive tax advantages beyond the 10-year maturity point. By contrast, taxable debt may offer better values at the front part of the curve even after adjustments for taxes.
Favor high-quality sectors
We take this opportunity to examine the current relationship between muni sector yields and their respective durations. Not surprisingly, the sector with the lowest credit risk and shortest duration (pre-refunded securities) sit at the lowest yield of only 2.3%. By contrast, high yield munis exhibit the highest credit risk and longest duration (7.6 years) except for housing bonds (9.1 years), but also provide the highest yield (5.4%). As a point of reference, the investment grade muni market as a whole plots somewhere in between these two extremes with an average yield of 3.1% and duration of 6.1 years.
We continue to favor investment grade munis in high quality sectors rather than lower rated high yield munis in the current uncertain economic environment. State governments, electric utilities, and water and sewer debt are among the best examples of sectors that should exhibit credit quality resilience. By contrast, not-for-profit hospitals and the private higher education sector face myriad challenges from a credit standpoint.
Monitor new issue supply trends
In addition to the behavior of US Treasury benchmark yields, the pace of new issue muni supply also has an important impact on market performance. At present, the forward calendar of new municipal bond sales (USD 7.6bn) remains well below its average over the past 12 months (USD 11.3bn). At the same time, investor demand has picked up as best evidenced by a recent reversal in mutual fund outflows. This supply/ demand imbalance represents an important tailwind for performance. As a result, portions of the muni market are now trading at expensive valuations compared with taxable debt.
In the near term, we anticipate supply to remain tight as market participants focus on the outcome of the next Fed meeting. The next opportunity for an uptick in supply is the March/April time frame, consistent with historical trends. In that instance, muni valuations are apt to cheapen from current levels.
Main contributor: Kathleen McNamara, Municipal Strategist, CIO Americas
Content is a product of the Chief Investment Office (CIO).
Original report - Municipal portfolio themes, 24 January, 2023.