Municipal Market Outlook: 6 Strategies For 2023

By Matthew Norton and Daryl Clements

2022 was one of the worst years in history for municipal bonds, as soaring inflation and rising rates drove prices lower. The Bloomberg Municipal Bond Index fell 8.53% for the year. Yields hit decade highs as spreads widened – tripling for muni credit alone – while anxious investors rushed to the exits. Market conditions did improve in the fourth quarter, as some investors were attracted to the substantially higher yields and much better return prospects.

We believe that 2023 will be a much better year for municipal bonds as they should resume their historical role of income generation, capital preservation and offset to equity volatility. However, while the long-term prospects of municipals look bright, there are some near-term hurdles to clear.

Near-Term Bumps Ahead, but Less Choppy Conditions on the Horizon

We expect the market to remain choppy in early 2023, since inflation remains stubbornly high and the Fed has signaled more rate hikes to combat it, which could further elevate yields.

But there’s a gap between Fed expectations and the market, which is pricing in a lower terminal rate (the rate at which the Fed stops hiking) and a faster pivot to rate reductions. We think a terminal rate of 4.75% to 5% is likely—slightly less than the Fed has signaled.

While yields could increase modestly in the coming months, the fact that they’re already so elevated means that they have some cushion against more potential rate hikes. Our research suggests that, given current yield levels, it would take a rise of approximately 1% in the 10-year US Treasury for intermediate muni returns to turn negative. However, we think increases of this magnitude are unlikely, given that the pace of rising Treasury yields will likely moderate as we approach the Fed terminal rate.

Perhaps more intriguing is the range of possible returns under reasonable interest-rate scenarios. Assuming 10-year US Treasury yields fall to 3% over the next 12 months, a portfolio with a 4% yield-to-worst, 6-year duration and A+ average credit quality could be up approximately 6%. Conversely, if 10-year US Treasury yields rise to 4.25%, returns could rise nearly 2%. Furthermore, if credit spreads were to narrow, as we expect, returns could be 1% to 3% higher than these scenarios. The range of potential outcomes is skewed to the upside, given the starting yield in portfolios is much higher to begin 2023 relative to 2022.

Meanwhile, bond issuers remain in good health, although tax collections have weakened, and recent budget gaps are making news. Still, when the economy eventually starts to slow, we think governments are equipped to withstand it, whether with their high “rainy day” reserves, budget flexibility or both. Rainy day funds are substantially higher than where they were prior to the global financial crisis and the 2020 pandemic recession. This credit strength is generally why issuer ratings upgrades have outpaced downgrades for six consecutive quarters—and defaults are rare.

Moreover, we believe any recession in the cards will be much milder than global financial crisis and the 2020 pandemic shutdown. For example, in the less severe recession of the early 2000s, municipal credit spreads for BBB-rated bonds peaked at narrower levels than where BBB municipals are trading today. This means municipal credit spreads may not have to widen substantially should we enter a recession.

As the year progresses, we expect market conditions to improve, but investors should expect some bumpiness along the way. Below, we address these challenges and opportunities.

Six Strategies for Flexibility in 2023

Even with a more encouraging backdrop, we expect volatility in the near-term. Portfolios should be flexible to opportunistically position in a dynamic market. But we also expect the upward pressure on yields to ease as inflation moderates and the economy slows during the year. Muni investors will need to leverage the market’s many tools as conditions shift.

1. Look to municipal credit. Mid-grade and high-yield muni spreads widened significantly in 2022. Spreads for BBB-rated munis, for example, tripled to 150 basis points by year-end. Today, muni credit offers not only extra yield, but also the potential for a relative price boost as the bonds’ spreads narrow versus AAA-rated municipals. Wider spreads in sectors such as healthcare and toll roads are especially appealing, but careful research and issuer selection will be important, since 2023 could present an economic downturn.And while credit can significantly boost income potential, it doesn’t necessarily add significant risk, since issuer fundamentals remain strong. In fact, defaults are rare, as are ratings downgrades, even during recessions. That’s why we believe demand will soon turn positive for mid-grade and high-yield credit. In our view, both are likely to outperform in 2023.
2. Consider cross-market opportunities, such as Treasuries. Sometimes yield environments require maneuverability beyond munis to seek potential returns or manage risk. For example, short-maturity Treasuries currently offer an after-tax yield advantage over short-term munis, which have become relatively expensive. But because this relationship is highly variable, being flexible is the best offense.
3. Barbell maturities. There’s no all-weather strategy to reach a duration target. Depending on rate expectations and the shape of the yield curve, a laddered or bulleted approach may work best. But barbelling—pairing short and longer bonds—may lead to better investment outcomes in the current environment, especially if the municipal yield curve continues to flatten.
4. Adopt a neutral duration target. As the rate cycle nears its end, it no longer makes sense to have less interest-rate risk, in our view. But investors should prepare to make small tactical changes to navigate interest-rate risk as the environment changes. For example, it may make sense to extend duration when inflation is coming under control and growth is slowing, because both indicate that yields won’t rise further, or could even fall.
5. Harvest investment losses. Tax-loss harvesting lets investors deliberately sell at a loss to offset taxes on gains elsewhere. It can also boost performance when tax savings are reinvested in higher-yielding bonds.
6. Deploy technology to gain an edge. The municipal market is incredibly inefficient, with over 1,000,000 bonds to choose from. It’s a big data market, which is why utilizing technology can give investors a substantial advantage. Speed and accuracy are vital in tax-loss harvesting, not to mention alpha generation. Managers who excel at it apply cutting-edge technology to process data, make trades and maximize pricing inefficiencies throughout the year, not just at year-end.

With substantially more attractive yields, the worst may be behind municipal bond investors. While there could be more bumps ahead early in the year given an uncertain outflow picture, the intermediate and longer-term prospects look quite strong. History supports a rebound in the market as munis have recovered nicely in the year following an outflow cycle.

The impact from inflation and rising rates could remain uncertain for a while, but a patient and flexible strategy should serve investors well as these and other factors play out.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.