GW&K Municipal Bond Strategies Investment Commentary – 4Q 2021

Municipal bonds posted mixed returns in the fourth quarter—short maturities barely broke even, held back by the potential for an accelerated rate-hike cycle, while the long end rallied on declining growth expectations. Municipal bonds outperformed Treasuries across the entire curve, buoyed by a strong technical environment that had been in place all year. The broader market, meanwhile, experienced its second major selloff of 2021, though most of the losses were likewise concentrated at the short end, while the long end saw solid gains. Back in the first quarter, recall, the long end had led the slide, as investors repositioned during the so-called “reflation trade.” This time around, the results reflected a market trying to juggle elevated growth and inflation against tighter monetary policy, less fiscal stimulus and the dampening effects of the Omicron variant. With inflation topping 30-year highs, the Fed executed a well-telegraphed hawkish pivot, doubling the pace of its expected taper and signaling as many as six quarter-point rate hikes over the next two years. The “transitory” moniker was also dropped from the policy statement, a nod to the reality that the spike in price increases is expected to linger far longer than originally anticipated. While two-year rates jumped 45 basis points over the quarter in reaction to the new messaging, 10-year rates were essentially unchanged. Whereas the 30-year rallied 14 basis points, an indication that investors believe the Fed will either succeed in keeping inflation at bay or damage the economy in trying.

Municipals charted their own path throughout the fourth quarter, largely ignoring the volatility in the Treasury market. After a brief hiccup in October, the market regained its footing in November and December. The catalyst was a seasonal boost in reinvestment flows against a backdrop of stable to falling issuance. In Washington, the House passed a version of the Build Back Better legislation, but left out key provisions that the municipal bond market lobbied hard for, including one that would have restored tax-exempt advanced refunding transactions. With that provision off the table, it seemed clear that the scarcity premium enjoyed by tax-exempt paper would persist further, an impression reinforced by the subsequent rally in municipals even while the Treasury market was in the midst of a pre-Thanksgiving Day slide. Meanwhile, the fundamental momentum remained intact. In November, Congress finally passed the bipartisan infrastructure bill, shoring up existing funding commitments and adding new federal grants to be used by all levels of government. Tax receipts continued to pour into state and local coffers, while outsized stock market gains helped bolster the funded status of pension systems across the board. For the quarter, the municipal curve mimicked the flattening of the Treasury curve, though short tax-exempt rates were up far less than their taxable counterparts, while longer-term yields fell by more. Those dynamics capped a year of outperformance that enabled municipals to stand as one of the few investment-grade fixed income sectors to post positive returns for 2021.

From both a technical and fundamental perspective, the municipal bond market enters 2022 on a solid footing. The biggest questions moving forward involve valuation and the pace of improvement from here. After a year that saw a record $100 billion pour into industry mutual funds, it’s hard to envision a material increase in retail demand. The same can be said for credit spreads, which blew out dramatically during the early days of the lockdown but have since rallied back to post-2007 tights. Even nominal rates, though well above the historical lows reached in the summer of 2020, begin the year at levels that would have been all-time lows before the onset of the pandemic. The resilience of municipal bonds in the face of broader weakness has left relative value ratios nearly two standard deviations rich to their long-term averages. And yet, the case for municipals remains compelling when you consider where we are in the market cycle. With asset valuations at record highs, investors would be well advised to remember the low correlation of municipal bonds with riskier securities, like equities, commodities, real estate and high yield. Backed by unprecedented federal support, conservative budgeting and its status as one of the few high-quality tax shelters, municipal bonds are in good shape to weather any repricing in the broader markets. To be sure, investors are currently paying a meaningful premium for such an attractive and reliable haven, but with few things as valuable as sleeping well at night, that shouldn’t come as much of a surprise.

Disclosures

Indexes  are  not  subject  to  fees and  expenses  typically  associated  with  managed  accounts  or investment funds. Investments cannot be made directly in an index. Index data has been obtained from third-party data providers that GW&K believes to be reliable, but GW&K does not guarantee its accuracy, completeness  or timeliness. Third-party data  providers make  no  warranties  or  representations  relating  to  the  accuracy, completeness or timeliness of the data they provide and are not liable for any damages relating to this data. The third-party data may not be further redistributed or used without the relevant third-party’s consent. Sources for index data include: Bloomberg (www.bloomberg.com),  FactSet  (www.factset.com),  ICE  (www.theice.com), FTSE Russell (www.ftserussell.com), MSCI (www.msci.com) and Standard & Poor’s (www.standardandpoors.com). Performance results reflect the reinvestment of dividends and income and are expressed in U.S. dollars.  MSCI Index returns are presented net of withholding taxes. This represents the views and opinions of GW&K Investment Management and does not constitute investment advice, nor should it be considered predictive of any future market performance. Opinions expressed are subject to change. Past performance is not indicative of future results.

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