Midyear Muni Market Outlook

Summary:

It’s been a case of one step forward, two steps back for muni bond investors this year. What started out as one of the best January’s in recent memory for munis, quickly turned into one of the worst February’s on record. And monthly returns have been uneven since. So, what can muni investors expect going forward? In this edition of the LPL Street View, we share our thoughts on what investors could expect over the second half of the year.

The first half of the year ended last week and it probably didn’t go the way many fixed income investors had hoped—particularly after the historically awful year last year. It wasn’t a horrible start- more in line with recent years—but expectations were high this year with some calling 2023 the year for bonds. But the themes that negatively impacted fixed income investors last year carried over into this year as well- namely inflation and the Fed. While many, including us, thought the Fed would likely be done raising rates at this point but given the still high (but falling) inflation levels, it looks like the Fed isn’t quite done just yet. Our base case is the Fed may raise rates one more time (perhaps two) but is close to the end of the rate hiking campaign. And that could be good news for muni investors.

The Fed’s goal has been to take the fed funds rate into restrictive territory to make the cost of capital prohibitively expensive to slow aggregate demand, which should allow inflationary pressures to abate—and we’re seeing signs that inflation is in fact falling. Then what happens? Well, after winning its fight with inflation, the Fed will likely start to cut rates as early as next year. After keeping rates at these elevated levels, the Fed will then likely take the fed funds rate back to a more neutral level, which economists believe is 2.5% or even lower. So just as the aggressive rate hiking cycle took bond yields higher (and of course bond prices lower), interest rate cuts will take bond market yields lower as well. In fact, once the Fed is indeed done raising interest rates we could start to see lower yields on intermediate-term securities before the Fed actually cuts rates.

And munis, which can provide additional tax-exempt income in higher-rate environments, have generated attractive after-tax returns at the end of Fed rate hiking campaigns. Over these last four hiking cycles, munis averaged a 9% after-tax return over the 12-month period after the Fed was done raising rates. So assuming this cycle at least rhymes with history, muni investors could see an additional 4-5% returns for the rest of the year (no guarantees of course). But we do think the second half of the year could be less bumpy for muni markets. 

But, the real wildcard for returns over the next six months remains investor flows. The market value of the muni market is around $4 trillion, and at 66%, retail ownership remains the largest ownership block of holders, with banks and insurance companies also large holders. While total yields for muni securities have increased and may be attractive to retail investors, the relative value proposition of munis still isn’t very compelling for banks and/or insurance companies, so the market is unlikely to get additional crossover support from those investors. So, performance for the second half of the year will likely be aided (or not) by the appetite of retail investors. As can be seen on the chart, record outflows, particularly out of mutual funds, in 2022 have been followed by further outflows this year (aside from January). Despite still strong fundamentals and improved valuations, muni investors have, so far, been unwilling to stay the course. We think that changes though particularly if returns improve, which again we think they will.

While munis have outperformed a number of taxable fixed income markets this year, after the historically bad year last year, it probably hasn’t been the year (so far) that many muni investors had hoped for. But, with the Fed close to the end of its rate hiking campaign, we could see a smoother path for munis in the second half of the year. Despite a slowing economy, many state and local municipalities are still is a good position compared to history. And while tax revenues may have peaked, high cash balances and reserves should allow most issuers to adapt to an economic slowdown. Total yields remain above longer-term averages and since starting yields are the best predictor of future returns (over longer horizons), we like the prospects of solid returns for munis going forward.

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