Market bids farewell to 2022

Experts in muniland are reflecting on a year they say was challenging and a bit unexpected yet provided windows of opportunity and optimism for the coming year.

“Much of what drove 2022 was a gigantic surprise,” Tom Kozlik, head of municipal research and analytics at HilltopSecurities Inc. said in a December 16 interview. “Many were expecting or at least hoping for less drama,” following two years of market impact from the COVID-19 pandemic.

Negative funds flows were a major driver of market activity, followed by low issuance, the Federal Reserve’s fight against inflation and the Russian invasion of Ukraine.

“Many spent the first half of the year hoping that this reality was going to disappear, then when rates continued to move higher some fought it — and are still fighting it,” he continued.

“Rapidly rising interest rates, historic losses, and massive investor withdrawals all led to a year that investors would rather forget,” agreed Roberto Roffo, portfolio manager at SWBC Investment Services LLC, calling the overall tone “decidedly negative.”

Significantly higher inflation and a hawkish Federal Reserve that raised short-term interest rates quickly and significantly set the tone for the year, he said.

“Fixed-income investors that have been earning close to zero for a long time finally got what they have been asking for — higher rates,” he said. But investors also had to deal with lots of uncertainty and inflation — two factors they disdain, Roffo said. “2022 provided a significant amount of both, which had investors running for the exits.”

The rate increases in 2022 led to a very difficult technical environment for municipals, which prompted significant redemptions from open-ended mutual funds by retail investors, noted Ben Barber, director of municipal bonds at Franklin Templeton Fixed Income.

“Rate increases and subsequent NAV decreases typically lead to redemption cycles, but the unique aspect of 2022 is how long this redemption cycle has lasted,” Barber said.  

Previous cycles tended to be much more “violent” and short-term, he noted.

“2022 has been largely characterized by an overall rate increase that has led to consistent redemptions from open-end funds,” he explained. “As the redemption cycle caused technical pressure, munis underperformed the Treasury sell-off at the high-grade level and credit spreads widened within the muni market.”

Rising yields sparked hope 
Despite the volatility, some investors found an opportunity in yields, liquidity, credit quality, and other market technicals.

The bright side, according to Barber: With municipal underperformance, valuations versus the Treasury market reached attractive levels — especially on the longer end of the yield curve.

“Wider credit spreads have made the lower quality portion of the muni market attractive,” Barber said.

Others were able to invest at yields that were much higher than just a few months earlier, Hilltop’s Kozlik noted.

“It makes it more difficult for managers and investors to put money to work at a time when many would like to take advantage of a strong credit backdrop and opportunities when there are bonds available to buy,” Kozlik explained. “This was in contrast to 2020 and 2021 when it was very difficult to find bonds to buy because demand was so strong,” he added.

Volume could end 2022 at $383 billion or lower, an estimate Kozlik said in a November report was worse than the firm’s June 2022 revised forecast of $410 billion.

“Issuance came in less than expected because the Federal Reserve raised rates at a higher pace than we anticipated,” he explained in the report.

Meanwhile, other opportunities arose from the aggressive interest rate increases by the Fed, which gave safety-conscious investors significantly higher yields on the short end of the yield curve and “has provided total return investors good value along with a strong income stream on the long end of the yield curve,” SWBC’s Roffo said.

The appealing yields that emerged throughout the year provided investors with opportunities to earn more while taking the same, or even less, credit and interest-rate risk, Matthew Gastall, executive director and head of wealth management municipal research at Morgan Stanley, wrote in a Dec. 14 report.

“Short-end yields rose more aggressively than those offered in longer final maturities as fixed income markets anticipated future federal funds rate hikes,” he explained.

The fourth quarter, in particular, provided some relief from rising rates as inflation may have peaked, economic indicators are slowing, and the Fed is close to being finished raising rates, according to Roffo, who suggested these factors could provide positive returns going forward.

Others looked at the broader picture when citing the benefits of 2022.

“As rates were fueled by an aggressive Federal Reserve, escalated geopolitical tensions and the pandemic, liquidity in the muni market held up well, even as other asset classes, such as U.S. Treasuries struggled at times,” Dave Rudd, president of InspereX said in an interview.

Triple-A municipals quickly rose to highs of 2%-plus on one-year maturities from near zero and 4%-plus yields in 30 years from less than 1.50% at the beginning of the year, he noted.

“Income investors would have had to invest in bonds longer than 10 years just to get more than 1% yield,” Rudd recalled, noting that now triple-A benchmark bonds in one year are yielding approximately 2.50%, while 30-year paper is just under 3.50%.

“Heading into 2022, we all expected rates to rise, but the velocity of the move in rates seemed unexpected,” he said. “However, once we received new guidance from the Fed, the market embraced the higher for longer narrative and yields quickly repriced.”

In his view, one of the key drivers of increased activity throughout the year was swaps.

“In a year in which both stocks and bonds were under pressure, tax-loss harvesting was a tactic used aggressively by active managers taking advantage of the rate move,” Rudd explained.  

Another trend Rudd noticed among retail investors in 2022 was a shift out of bond funds and other asset classes into individual bonds, sparked by the upward move in rates.

Federal Reserve data showed U.S. debt securities directly held by investors rose by over $1 trillion between Q3 2021 and Q3 2022.  

“As yield has returned to markets, we’ve seen renewed interest in individual bonds and traditional fixed income strategies, like bond ladders,” he said. “In fact, in our recent survey of financial advisors, we found that 68% are using individual bonds, given the benefits of predictable income and diversification.”

Barber, too noticed, trends between the technicals and fundamentals, as well as the difference in flows from open-end mutual funds to separately managed accounts.

“Whereas the technical environment was very difficult with redemptions from open-end mutual funds, the credit fundamental environment continued its positive trajectory, with upgrades outpacing downgrades by a significant margin,” Barber said.   

Meanwhile, he said, the redemption cycle from open-end funds was both “intense and consistent,” but movement into separately managed accounts was “very significant.”  

New Year, new opportunities  
As negative as 2022 was, opportunities lie ahead, according to Roffo.

“While it was an unpleasant experience, the overall higher interest rates should provide a solid base for investors going forward” into the new year, he said.

The upcoming year may produce volatility and opportunity, Kozlik predicted.

Hilltop expects $350 billion in total municipal bond market issuance in 2023, according to Kozlik, as new money issuance will be dragged down by weaker economic growth whether or not the economy slips into recession.

In addition, higher rates will reduce refunding activity, he noted.

“The emotional roller-coaster is likely to continue for those who do not fully grasp the market reality … or for those who will try to fight the Fed,” he said.

At the same time, Kozlik noted, credit quality with state and local governments is “generally pretty strong.,”

Investors should gradually put money to work in the first quarter, he said.

“They should not try to time the market,” Kozlik said, “they should be content that levels are much more attractive now and will be into 2023 than they were previously.”

The new year could ring in an opportunity for investors, after volatility, spread widening on some lower-rated credits, and negative convexity where portfolio performance varied considerably, according to Morgan Stanley’s Gastall.

“As we journey into next year, volatility may surface again, and even create a perfect storm of institutional municipal outflows, even after broader bond prices advance,” he wrote in the Dec. 14 report. “If so, this development may represent yet another advantageous investment opportunity,” Gastall added.

He recommends a conservative yet income-driven strategy.

Tight credit spreads and recession risks support Morgan Stanley’s high-quality credit advocacy, Gastall pointed out. “For yield-curve exposure, we continue to favor a bifurcated approach that focuses on high-coupon-paying bonds with both short final maturities alongside longer kicker structures.”

Investors who want to add duration may consider bonds with longer first call dates, but “capped” final maturities that are laddered in yield curve sectors appropriate for risk-tolerances, Gastall suggested. 

“Overall, we believe this reality suggests that the future for municipal investors is now brighter,” Gastall added.

The best advice for investors looking at the municipal asset class, according to Franklin’s Barber, is to choose the level of interest rate and credit risk that is appropriate for their asset allocation and maintain that allocation over many cycles.

In order to take advantage of the tax-exempt income generated by tax-exempt munis,”investors need to be able to weather some short-term volatility, especially when it comes from the technical as opposed to the fundamental environment,” he said.

Craig Brothers, portfolio manager and head of fixed income at Bel Air Investments in Los Angeles, agreed that 2022 was challenging and 2023 may exhibit more opportunities, despite the likelihood of decreasing seasonal factors.

“The January effect might not be as big given all of the trading that was done over the last month as the money that might have waited was spent,” Brothers said.

“It is probably going to be a good year next year for bonds,” he said.

“While investors are still shell-shocked by 2022, the carnage has opened significant opportunities going forward that are all positive for fixed income,” Roffo added.