For muni bonds in 2023, less is more

The appeal of municipal bonds remains the potential for income generation free from certain taxes. But that focus—to the point it’s called the “tax-free” asset class—can overshadow the strength of their fundamentals. Credit quality tends to be robust, and historically the sector has lower default rates than comparably rated corporate bonds (S&P Research). Of course, as fixed-income instruments, the rules of supply and demand also apply. That could be a boon for the muni market in 2023. Despite a market correction in February, we expect an environment of low issuance and high demand to prevail for a host of reasons:

• We’re good The CARES Act and American Recovery Act sent unprecedented funds to state and local governments, hospitals, higher education institutions and airports, much of which they haven’t spent. Add to this better-than-anticipated tax receipts and issuers are flush with reserves. They simply don’t need to raise capital.
• It’s not usury, but… With every Federal Reserve hike, the cost to issue debt increases, and in less than a year, it has taken municipal interest rates from near zero to more than 4%, in some cases. We think policymakers will raise rates further, hold the eventual peak level for longer and resist easing until sometime in 2024. Now is not the time to refinance, let alone borrow money that isn’t particularly needed. Elevated rates also mean taxable refunding makes less sense.
• Proposals for raising millage getting little mileage New projects are often funded in part by increased taxes, either directly or used to pay down debt service. Raising income, property or other taxes is a tough sell in an inflationary environment, and voters also know a recession could be around the corner. All but the most needed infrastructure plans are unlikely to pass.
• About that recession Whatever nomenclature economists give the expected downturn, we think the muni sector could weather it better than the corporate sphere. Past performance doesn’t guarantee the future, but this has been the pattern in previous poor economic environments as residents must pay for essential services, some of which fund revenue bonds. 
• Washington, D.C., of course Debate within several stately buildings on the National Mall could indirectly impact the muni markets. Supply tends to dip around any Fed policy-setting meeting thought to result in rate action—and that’s all of them these days. Also, while we believe the U.S. will meet its obligations, the inability of lawmakers to raise the debt ceiling creates the sort of uncertainty and volatility issuers loathe.

Fed policy has pushed yields on the Bloomberg Municipal Bond Index to levels not seen consistently since before the Global Financial Crisis. This, along with their high-rated credit ranking and attractive tax benefits, should lead to heightened demand for muni bonds at a time when investors have become more comfortable returning to the fixed-income space in general, anticipating the imminent end of the Fed’s hiking cycle and moving on from the tumult of 2022.