Current muni yields offer investors an attractive entry point

Following a bumpy first quarter in the municipal market, opportunities are ripe and demand high as the upcoming second quarter approaches.

Municipal analysts say now is the time for investors to take advantage of the strength and resilience of the asset class after they spent a brief hiatus on the sidelines during a volatile first quarter.

With the late February sell-off in the rear-view mirror, higher yields and spreads are more readily available and offer an entry point for eager investors, municipal managers and strategists said.

Ben Barber, director of municipal bonds at Franklin Templeton Fixed Income
“The muni market is in a much better position post sell-off,” said Ben Barber, director of municipal bonds at Franklin Templeton Fixed Income.

“The muni market is in a much better position post sell-off, from both an absolute yield as well as a relative value perspective,” said Ben Barber, director of municipal bonds at Franklin Templeton Fixed Income.

Jeff Lipton, head of municipal credit and market strategy at Oppenheimer & Co., believes that the new market levels — with the 10- and 30-year benchmark yields up 42 and 37 basis points, respectively, since the beginning of the year — merit a look by investors and offer visible entry points, though rates could move higher.

“We think that retail investors are trying to reconcile the higher range of tax-exempt yield levels with still presently rich valuations,” Lipton said on Wednesday.

“Perhaps price discovery with more pronounced secondary bid-wanted activity is playing a role in this environment as comfort levels are being sought, yet we do believe that the technical foundation has the ability to sustain a generally positive fund flow trajectory,” he added.

In addition, Lipton said more spread in the new-issue market and the somewhat cheaper relative value ratios should continue to draw investor interest as long as market technicals remain steady, even as the 10-year Treasury benchmark has returned to pre-pandemic levels amid swelling inflationary concerns.

Municipal to UST ratios were at 67% in 10 years and 74% in 30 on Friday, according to Refinitiv MMD, while ICE Data Services showed ratios at 66% in 10 years and 75% in 30.

Softer bond prices caused a backup in relative value ratios at levels still reflecting historical tightness, according to Lipton.

While some said the ratios turned historically rich following the March Federal Open Market Committee meeting, they agree the overall market is still stable, improving and attractive.

Jeffrey Lipton
"We do believe that the technical foundation has the ability to sustain a generally positive fund flow trajectory,” said Jeff Lipton, head of municipal credit and market strategy at Oppenheimer & Co.

Despite the weaker tone after the meeting, municipals’ year-to-date outperformance over Treasuries remains “considerable,” according to Lipton. He said flows were “decidedly positive” during the last reported period, extending the advances made during the prior week.

According to the Bloomberg/Barclays performance indices, municipals outperformed Treasuries as the bond rout took hold of February sending returns for both asset classes into negative territory, and municipals continue to be in the lead with positive returns, while U.S. Treasury securities are losing over 1% month-to-date, Lipton noted.

“This is not surprising given that munis typically underperform a bond market rally and outperform a market sell-off,” he said in a March report.

‘Newly minted’ levels eye-catching
The municipal market continues to fare well after the historic sell-off that sent yields higher by 40 basis points on the 10- and 30-year triple-A benchmarks over a two-week period beginning Feb. 17, analysts said.

It was the largest sell-off since April 2020 during the height of the pandemic pressure.

Now, the municipal market is benefitting from a post-correction window of opportunity for yield-hungry investors, analysts said.

“The municipal market right now is a little more attractive and in step with the taxable market,” generating growing interest at the adjusted, post-correction levels, Jeff MacDonald, head of fixed-income strategies at Fiduciary Trust International, said.

On Monday, the generic triple-A general obligation scale in 30 years was still 35 basis points cheaper than it was back on Feb. 17 when the rout began, according to Refinitiv/Municipal Market Data.

The 2051 maturity of the triple-A GO yielded 1.76% on Monday, versus 1.41% on Feb. 17.

“Municipal price/yield performance has a historical tendency to lag moves in the taxable market,” MacDonald said.

“This behavior has been on display in 2021, with municipals lagging the backup in Treasury yields early in the year, catching back up, only to fall behind again in the U.S. Treasury 10-year move to 1.75% in the wake of the March FOMC meeting,” he said.

macdonald-jeff-fiduciary-trust-357.jpg
"The municipal market right now is a little more attractive and in step with the taxable market,” said Jeff MacDonald of Fiduciary Trust International.

MacDonald said this moved municipal to Treasury yield ratios back into historically rich territory.

“Traditionally the expectation would be for munis to adjust as they did earlier in the year, but that move could be more protracted in the current environment of fiscal relief for state and local governments, realized revenues coming in ahead of expectations, and a strong technical backdrop with solid investor interest and modest issuance.”

“Given that munis started their upward migration in yields after Treasuries, there may be more upside room to go,” Lipton noted in his report.

“Having said this, newly minted valuations may be catching the eye of those investors kept on the sidelines given rather frothy price levels and indecipherable market volatility of late,” Lipton added.

“We recognize the still-outsized stash of available cash awaiting investment guidance, as well as sustained muni product demand,” he said. Lipton noted a particular “desire” for taxable municipals given the needs of crossover and foreign buyers searching for above-average credit quality, portfolio diversification and, “more compelling” yield opportunities.

The adjustment is providing a “fundamentally improving story,” characterized by higher rates and steeper yield curve in an orderly setting almost a month later, according to MacDonald, who said the short-lived correction was constructive for both municipals and risk assets.

The sell-off was neither long enough, nor intense enough, to produce massive selling pressure, Franklin's Barber added.

“Because the muni market is retail-oriented, and the typical retail investor is very sensitive to NAV declines, redemptions out of mutual funds tend to follow a market sell-off,” Barber continued. “With a reasonable cash cushion, funds can survive a quick redemption cycle without too much selling.”

Barber said the primary market quickly returned to deals being significantly oversubscribed, “and the Street has become more interested in going long muni risk,” he said.

Lipton, meanwhile, said he is expecting 2021 may see more disruption and volatility in fund flows, in the form of either a slower pace of inflows or even intermittent bouts of outflows, but not sustained.

Selective strategies
Though MacDonald predicts the higher yields and steepening yield curve in the tax-exempt market will likely continue in the second quarter and into 2021, he also advises caution.

“We are encouraging investors to stay in the short to intermediate part of the yield curve, but still capture yield and keep interest-rate risk on a short leash,” MacDonald said.

While market fundamentals are improving, he recommends investors choose the less sensitive five- to seven-year intermediate slope of the yield curve in the current market.

“The longer the maturity, the more sensitive it is,” which could create some underperformance on the long end versus intermediate bonds, he noted.

“Even after the move higher earlier in the year, municipal prices have again become rich to the taxable market and we have not been aggressive buyers and not stretching or reaching for credit risk since the yield compensation wasn't there,” MacDonald explained.

Despite the increased opportunities post-correction, “we are not aggressively taking on additional municipal credit and interest rate risk,” MacDonald added.

MacDonald suggests limiting credit and interest rate risk, especially in the current environment after the recent FOMC meeting after which municipals richened relative to their taxable counterparts.

Barber also believes there continues to be value in security selection down the credit spectrum.

“The high beta names in the triple-B and double-B universe moved with a pretty high degree of correlation to high grades,” Barber said. “Spreads, from our perspective, continue to imply default rates that are much higher than we’re currently experiencing or that we view as reasonable going forward,” he continued.

MacDonald compared the recent correction to March and April 2020, but said that disorder was more credit and fundamentally driven during the height of COVID-19 shutdowns.

“This is not fundamentally based because the funds are improving at an aggressive rate,” he said. “This is more inflation-growth and policy-growth based.”

MacDonald expects the market to continue to improve and present opportunities.

“Past this adjustment, we will be more stable in credit, two-way flows, and investor appetite,” MacDonald said.

Recalibration and rate forecast
A neutral rate forecast, economic recovery, and government intervention continues to boost market technicals and fuel demand going forward, analysts noted.

“With the worst of the pandemic seemingly behind us and progress on the vaccination front engaging successfully beyond expectations, the economy is well-poised to pursue a strong growth trajectory in the coming quarters,” Lipton said.

“Given that the Biden administration is likely to now focus on higher individual and corporate tax rates, demand for muni tax-exemption, particularly from institutional buyers, can be expected to expand and such demand may very well lead to continued muni outperformance,” Lipton continued.

The market has recalibrated since the correction and economic and political developments are aiding the overall climate, MacDonald added.

“For investors looking for relief on the supply side, there is higher tax-exempt income as we move beyond the pandemic and into an agenda focused on infrastructure,” which will likely be financed through the municipal market, he suggested.

The Georgia Senate runoffs, the Democratic control of the House, the Senate, and the White House, the $1.9 trillion stimulus package, and the progress regarding COVID-19 vaccines, “pulled forward expectations for aggressive recovery in growth and inflation,” MacDonald said.

“While we expect the curve to steepen and rates to move higher in 2021, we expect it to be a bit more orderly than in February with the repricing of rates in taxables versus municipals, which traditionally lag performance,” he added.

“The longer end will participate in that move and we will be patient about how that evolves over the course of 2021,” he said.

With the Federal Reserve Board paused for an extended period, the economy reopening and recovering, and the approval of the $1.9 trillion stimulus package, that should promote growth and reflation, according to MacDonald.

Overall, Barber said Franklin currently has a positive outlook for the municipal market, from both a technical and fundamental side.

He noted that demand will continue to be strong from investors, driven by three main factors, including increasing income taxes; reallocation from higher equity percentages in personal accounts; and an improving fundamental story given the expected federal stimulus package.

“We believe supply will continue to be moderate at best, and many states we believe will have a net negative supply calendar,” Barber said.

Lipton, meanwhile, noted that taxable municipals are displaying negative returns given the taxable municipal index is more interest-rate sensitive.

“We certainly observe mounting concerns over advancing inflation, heavier stimulus, and the market’s hold-out for a Fed pivot,” Lipton said.

Overall, Lipton maintains that compelling market technicals coupled with a favorable credit outlook have the ability to unlock further performance in 2021.

“Accordingly, we can point to better high-yield flow activity relative to other segments of the municipal bond market and we think that this dynamic could continue for a while longer, although it remains questionable as to how much more performance there is to unlock.”

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