Finding value in second quarter after volatile first
5 min read
Despite volatility, bank failures and heightened macroeconomic uncertainty in the first quarter, the municipal market offers pockets of opportunity in the second as a result of higher yields and overall fundamental strength of the asset class.
“If you look at yields in the 30-year part of the curve, we are seeing the biggest opportunity in over five years,” said Megan Poplowski, director of municipal research and co-manager on several municipal funds managed by MFS Investment Management.
Poplowski noted that 30-year paper was yielding above 3.00% versus an average of 2.44% since 2017.
The market strengthened on the heels of declining Treasury yields for the first week of the second quarter, as the 30-year municipal benchmark yield fell to 3.18% as of Monday, according to Refinitiv MMD. Still, the long-end remained attractive from a historical perspective, municipal experts said.
“If you’re willing to take on that kind of duration, you should be investing” during this period of attractive yields, Poplowski said.
She expects near-term volatility but said investors are prudent to stay invested and increase their exposure to credit to take advantage of the current yields, some of which are the highest since 2017.
While investors are not immune to uncertainty, she said they are being compensated for taking interest rate risk, especially on the long end of the yield curve, which she said is a major theme driving the current market activity.
Poplowski suggests investors swap out of previously purchased bonds and reinvest at the higher yields and higher credit quality available in the current market.
“It’s a good opportunity to do that,” she said, noting that MFS has a fundamentally stable view across most municipal sectors.
Earlier this year, she found value in a variety of bond structures, such as alternative minimum tax, planned amortization class bonds, insured bonds and pre-paid gas bonds, as well as by adding convexity to the portfolios.
“Even with the drop in yields in the first quarter, investors are finding opportunity in yield levels not seen in a long time,” Roberto Roffo, managing director and portfolio manager at SWBC Investment Company, agreed.
While he said no two quarters are exactly the same, the volatility experienced in the first quarter will most likely continue in the second quarter.
“The second quarter has started out on a strong note and while there may still be some volatility from erratic economic indicators going forward, I believe that crack in economic strength will begin to show and affect bonds positively,” Roffo said.
New issuance should also continue to remain low in the second quarter, keeping dealer inventories “lean” and investors looking for value, he noted.
“I expect the quarter to end on a positive note similar to the first quarter as the Federal Reserve approaches the end of their interest rate hikes and the previous hikes start to take a toll on the economy,” Roffo said.
Besides the credit strengths and higher yields, the market overall is well positioned to weather any stress stemming from the lack of supply and possible recession, Poplowski said.
“We think that even considering the increased possibility of a recession over the next couple of quarters, municipal borrowers are resilient and are coming into this period of volatility with strength,” she said.
It is also taking the banking collapse in stride following the closure of both Silicon Valley Bank in California and Signature Bank in New York in early March.
While not a systemic crisis, and municipals had a largely muted response, the bank failures added to market uncertainty, she said.
There is a cautious tone in general in markets as economic data comes in softer and the Federal Reserve continues its rate hike cycle.
Referring to the most recent 25 basis-point hike from the Federal Reserve Board in late March, she expects that cycle to continue, but predicted it will taper off by the end of the year.
Supply challenges
Supply was down 30% year-over-year in March, and down 27% for the first quarter of 2023 year-over-year.
“Supply is below the historical average, but that’s where the muni market finds opportunities,” she said. “There has not been the uptick in supply that many expected to see by now, and I don’t see that changing dramatically over the near term.”
Issuance will remain slow in the second quarter of 2023, and for most of the year, noted Tom Kozlik, head of public policy and municipal strategy at Hilltop Securities.
Higher interest rates will be to blame for the lack of issuance going forward, Kozlik said.
“The higher interest rates just are not allowing refundings to work in most cases,” he said. “There will not likely be heavy months of issuance or months where we see consecutive $40 billion a month, or $40 billion a month for three months in a row.”
Interest rates are likely to remain elevated compared to 2021, even higher compared to 2022. “This is attractive for investors, but elevated rates means issuance will be lower than 2022,” he said.
Volatility aside, Poplowski said she is not planning on making any changes to her objectives or the long-term, value-added municipal strategy she employed coming into the new year since it was dictated by the general trajectory of events she predicted.
“Coming into 2023, we expected near-term volatility and through 2023 we expected the Fed would continue to increase rates in the near-term and taper off by year end,” she said, noting that under that scenario, her strategy includes adding duration and finding value in the strong credit fundamentals of the municipal market.
“The near-term volatility will continue, and there will be less supply and strong demand for the supply that is there,” she said.
Poplowski advises investors to “strike a positive note — it’s a good time to invest in municipals because of the fundamental strength of the asset class,” despite any looming fears of recession.
“Munis have a history of remaining resilient with a low default rate and high quality,” she said. “We are now at a point where yields are now more attractive than they have been in many years.”
Kozlik said the muni market is stable and saw positive returns in March, despite the outside factors that occurred in the first quarter.
“This is an important point to consider if we see the economy slow,” Kozlik said. “Most investors should consider how strong credit quality is with public finance entities while we stare at a possible recession.”
