Municipal bonds could provide stability in an uncertain market

The failure of two tech-focused lenders in March rippled through fixed-income markets, broadly shifting bond yields down across the board. The municipal bond market is no exception, with yields falling from above 4.0% in October 2022 to a current yield of 3.4% as of April 28, 2023. The recent failure of yet another bank has sparked further worries around the health of the global financial system. While we do believe these events present some marginal risks for investors, we remain constructive on the municipal bond market, especially as the risk of recession grows.

Banks own a significant portion of the muni market

One potential risk of the growing stress on the financial system is the possibility that banks will begin to sell off their municipal bond holdings to meet their liquidity needs. Banks are the third largest holder of municipal debt, owning roughly 15% of the total market. Most of this ownership is concentrated at the 10 largest banks, with regional banks owning only a small fraction of the market. In addition, more than 40% of this municipal debt is currently classified as held to maturity.¹  With the creation of the Bank Term Funding Program in March, the U.S. Federal Reserve has allowed banks and other eligible depository institutions to take out loans of up to one year, permitting them to pledge U.S. Treasuries, agency debt, and mortgage-backed securities as collateral while valuing these securities at par.

In aggregate, we believe these factors make it unlikely that banks would need to sell off any substantial amount of their bond portfolios, flooding the market. Instead, we believe that any selling of municipal debt is likely to be at modest levels, with the market easily absorbing any new supply.

However, news that the FDIC would be facilitating the sale of municipal bonds from the portfolios of two of the failed banks, totaling just under $7.5 billion combined, did contribute to weak performance in April as this event coincided with low demand, a seasonal quirk of the municipal bond market. 

The impact of tightening lending standards

Another risk that we’re keeping an eye on is the potential impact on lending standards moving forward. Currently, banks commonly engage in direct lending to municipalities, bypassing public markets. If banks tighten their lending standards, restricting issuers’ ability to access direct loans, this too could cause an uptick in supply for the municipal bond market.

Currently, new issue supply is down roughly 23% year over year for tax-exempt bonds.² This leads us to believe the market would welcome and could easily absorb a minor increase in supply. However, uncertainty around the likelihood of financial contagion and what impact these events might have on banks’ willingness to lend present a risk to municipal bond markets and could provide a headwind for performance going forward.

Municipal bonds have historically performed well after periods of stress

Despite these risks, we remain constructive on the municipal bond market and believe we’re still in the early innings of recovering from last year’s significant drawdown. Historically, municipal bonds have tended to rebound following periods of stress. 

Source: Morningstar Direct, as of March 31, 2023. Performance of periods greater than one year is cumulative. It is not possible to invest directly in an index. No forecasts are guaranteed. Past performance does not guarantee future results.

Widening spreads create opportunity

Credit spreads have widened on BBB- and below rated credits this year as uncertainty over the economic backdrop grows; however, this spread widening has occurred while the underlying fundamentals at the state and local level remain strong. In addition, most revenue bonds are used to finance essential services and projects that tend to perform well even during times of economic stress.

Source: Bloomberg, Manulife Investment Management, as of March 31, 2023. Yield to worst (YTW) is the lowest potential yield calculated by taking into account an issue’s optionality, such as prepayments or calls. Past performance does not guarantee future results.

A wider spread on these lower-rated bonds relative to a AAA bond signals a greater likelihood for these bonds to experience a downgrade or default, but the strong fundamental backdrop for these securities indicates that this risk might be overstated. In addition, history shows that municipal bond ratings tend to be stable across the market cycle, suggesting this spread widening has created an attractive relative value opportunity for municipal bond investors even if the economy tips into recession.

Historically, municipal bond ratings more stable than corporates

As the risk of recession looms, we believe that the opportunity presented by municipal bonds becomes even more compelling. History has shown that higher-quality, intermediate-term bonds such as municipals have tended to do well in late-cycle and recessionary market environments. One reason for this is that municipal bonds have historically had a lower rate of defaults and less rating drift than corporate bonds. 

Source: Moody’s Investors Service, National Bureau of Economic Research, Manulife Investment Management, April 21, 2022. Most recent data available.

Elevated yields across most parts of the yield curve also position municipal bonds well against corporate bonds. On a tax-equivalent basis, A-rated revenue bonds are now offering a significant yield advantage relative to A-rated corporate bonds, especially those with a tenor of 12 years or longer.

Source: Bloomberg, as of May 23, 2023. TEY refers to tax-equivalent yield.

In our view, these yields, along with municipal bonds’ tendency toward stable credit ratings, have created an additional opportunity for investors to generate income without taking on a significant amount of risk.

As market uncertainty continues to linger, we’re keeping an eye on the risks that face investors, especially if stress in the banking system continues to spread. However, we believe municipal bonds remain uniquely well equipped to handle a souring economic environment and could provide portfolios with a higher level of price stability in a recessionary environment when the incidence of defaults and downgrades tends to increase.

1 “Complete Set of Bank Municipal Bond Holding Data as Reported by the FDIC, as of 4Q22,” J.P. Morgan, March 21, 2023. 2 “Municipal Monthly Index and Data Chartbook:  March 2023,” J.P. Morgan, as of March 31, 2023.