2022: A new year and new outlook on the municipal bond market

With the turn of each new year comes a time for change and high hopes. These feelings are commonly felt as we exchange our calendars, both as an opportunity to shake off any challenges faced in the year prior, and as a chance to reflect on our goals and set new ones.

For investors in the municipal bond market, 2021 proved to be a year of hurdles. Tighter spreads between comparable bonds and lower overall yields made 2021 a difficult year for muni investors to earn interest income from their investments. Disruptions to global supply chains, the emergence of a COVID-19 variants and rising inflation impacted a variety of U.S. economic sectors, the year saw financial ebbs and flows the likes of which have been unprecedented.

However, with a brighter market outlook expected for 2022, this is likely to change, particularly for investors in the municipal bond market.

Continued concerns regarding COVID and inflation
At the forefront of the mind of virtually every investor or economist regarding the performance of the municipal bond market (among others) is the recent emergence of the latest COVID-19 virus variant, Omicron. After more than 18 months of worldwide social and economic relief efforts, Omicron’s emergence and subsequent spread (which has since been recorded to be far higher than previous iterations of the virus) has thrown a proverbial wrench in global factors to mitigate the pandemic’s spread and severity.

Adobe Stock

The silver lining with Omicron is twofold. Firstly, health professionals have reported that Omicron’s adverse health effects are, on average, far less severe than previously recorded strains of the virus. Secondly, most governing bodies seem to have “learned their lesson” regarding the pandemic.

Last year, inflation in the U.S. soared to its highest rate in nearly four decades. Because the Federal Reserve has yet to officially respond to any potential correlation between heightened rates of inflation and interest rates for most investment markets going into 2022, investors in municipal bonds should approach 2022 with a blend of caution and optimism, especially as interest rates on the 10-year Treasury are projected to rise as high as 1.75%-2% this year. This is especially true because, as yields and prices move inversely to one another, the price of municipal bonds can be expected to decline if interest rates continue to climb.

In the early months of 2021, there was widespread speculation as to how the lingering effects of the COVID-19 pandemic might continue disrupting U.S. investment markets, including the stock market and municipal bond market. Both markets were able to perform exceedingly well, and the U.S. economy was able to bounce back beyond the expectations of most, allowing the U.S. to experience an average GDP growth rate of nearly 6.5% over the course of 2021.

Global economic slowdowns
For the municipal bond market, the quick stabilization of the country’s economy allowed its investors to eschew many of their fears regarding credit concerns. According to Charles Schwab’s Cooper Howard, “an imbalance between supply and demand” is one of the reasons the municipal bond market outperformed most other fixed-income investment sectors, as well as a reason behind the market’s experiencing tighter spreads, “and the riskier portions of [municipal bond] market outperforming those with less risk.”

Furthermore, according to the Investment Company Institute, investments into the municipal bond market remained positive for 78 of the 80 weeks prior, as of Nov. 17. This signaled strong demand from investors in the municipal bond market while the supply of tax-exempt municipal bonds over that timeframe remained lower, leading to higher prices and tighter spreads.

This could pose trouble in the event that interest rates continue to rise to their projected levels for 2022, as both higher prices and tighter yields could cause demand in the market to lessen, prompting a greater number of investors to withdraw their capital from municipal bonds and related funds.

Market outlook for 2022
The municipals-over-bonds (MOB) spread is one of the most commonly used metrics to assess the attractiveness of the municipal bond market to investors. Because it is equated to the ratio of yield on top-performing municipal bonds relative to a Treasury bond of equal or similar maturity prior to adjusting for taxes, the MOB spread for most mature municipal bonds remained historically low throughout 2021, as other bonds and investment avenues achieved higher yields.

If demand in the municipal bond market drops, freeing up supply, MOB spreads can be expected to rise, granting their yields an opportunity to grow more closely in alignment with their long-term maturity averages. Should this prove to be the case, then MOB spreads for lower-rated bond issuers can simultaneously be expected to rise to more predictable levels, offering investors a chance to receive greater yields in exchange for added risk.

Additionally, the failure of congressional Democrats to pass their Build Back Better infrastructure package in 2021 means the tax hikes proposed within the bill are unlikely to take effect in 2022.

Though municipal bonds tend to create higher yields at higher tax rates, the current breakeven tax rate is 47.1%, meaning that if an investor’s combined tax rate remains above 47.5%, their municipal bonds could still create higher yields than other comparable corporate bonds. This projection may turn out to be true by the close of 2022, especially if tax rates do not rise, prompting the breakeven tax rate to fall.

Concluding thoughts
If 2021 was a year of uncertainty in the municipal bond market, then 2022 may turn out to be a year of broader stabilization, compared to its historical performance. Overall, this is due to projections for credit conditions to remain favorable and defaults to remain low for municipal bond issuers, as well as a steady rise in revenues reported in 2021.

Though the outlook for the municipal bond market may remain somewhat volatile — at least for the first few months of 2022 — investors might expect better outcomes than in 2021, especially if their investment strategy involves targeting bonds with lower durations and price declines in the event inflation and interest rates continue to grow.