Municipal Bonds: Is it Safe to Get Back in the Water?

Municipal market participants are still recovering from the municipal market beatdown of 2022, which saw the worst performance (-8.53%) of the Bloomberg Municipal Bond Index since 1981.

Rising interest rates driven by the Fed’s inflation-fighting tightening strategy drove individual investors out of open-end mutual funds as outflows totaled $148 billion for the year. These redemptions created heavy selling pressure for fund managers. Average daily “Municipal Bid Wanted” activity reported by Bloomberg for 2022 was $1.358 billion. This was nearly two-and-one-half times the average daily amount of $556 million for 2021 and nearly twice the daily average for 2017-2021 of $708 million.

The extreme selling pressure required municipal market broker-dealers to adjust bid/offer spreads as they tried to match sellers with buyers and provide liquidity in a volatile Treasury market environment that made hedging risk positions more challenging.

While there were some brief periods of positive performance in May, July and November, the net result of the 2022 municipal bond market sell-off is that tax-exempt bond yields have started the new year at significantly higher levels than a year earlier. On January 3, 2023, AAA tax-exempt yields in five years were at 2.53% - 195 basis points (bps) higher than a year ago, in 10 years at 2.62% - 157 bps higher and in 30 years at 3.56% - 206 bps higher.

More Attractive Yields

Higher absolute yield levels provide an attractive “re-entry” point for municipal market investors. Many individual investors that were year-end tax management sellers have turned into buyers to start the year. Selling pressure has subsided and along with a limited municipal new issue calendar, demand for municipal bonds has been strong for the first two trading weeks of 2023. AAA tax-exempt yields have declined 30 bps in 5-year bonds, 29 bps in 10-year bonds and 28 bps in 30-year bonds from January 3rd to 13th.