Perspectives

Municipal bonds posted their strongest quarterly performance in over a decade, partially erasing what still amounted to the worst annual loss in 40 years. With a struggling Treasury market providing little direction, returns were instead powered by a combination of scant supply and building demand. New issue volume for the fourth quarter declined 40% on a year-over-year basis, creating a scarcity premium that was turbo-charged by the need for investors to reinvest seasonally high coupon and maturity redemptions. Although mutual funds continued to experience significant outflows, likely exacerbated by year-end tax-loss selling, the bid-side remained strong and picked up steam as the quarter progressed. In fact, after a modest selloff in October, tax-exempt yields staged a breathtaking turnaround, plummeting 70-90 basis points through mid-December. Even with that rally, however, rates were still up 1.6% to 2.3% from January’s historically low starting point, leaving no escape from the sharply negative annual performance that materialized across the entire curve.

Although municipal bonds outperformed Treasuries over the quarter, they were still directionally influenced by the underlying forces driving the broader market. Early in the quarter, interest rates shot up due to still-elevated inflation, tight labor markets, and hawkish saber rattling from central banks. By October 28, the yield on the 10-year Treasury had risen 40 basis points for the month to close at 4.24%, its highest level since 2008. From there, however, sentiment turned as the lagged effects of contractionary policy seemed to take hold. Key prints on inflation decelerated from their peaks, creating a sense that the worst may be over. A pullback in manufacturing and a softening in unit labor costs were also contributing factors. And while the Fed continued to talk tough on keeping policy restrictive, a downshift to a 50 basis-point hike in December after four consecutive 75 basis-point increases lent further credibility to the slowdown narrative. The futures market even started pricing in a couple of rate cuts for the back half of 2023. From its October high, the 10-year Treasury yield dropped 36 basis points the rest of the way, ending December more than 50 basis points below the yield on the two-year, the steepest inversion of that segment of the curve since the early 1980s.

Don’t be fooled by all the hand-wringing over what a terrible year 2022 was for bonds. In fact, long-term investors should be grateful for what transpired. Make no mistake, ultra-low interest rates are a threat to savers, especially those artificially manufactured by well intentioned governments. It was critical to break out of that destabilizing cycle and mark-to-market losses were a small price to pay to get there. Municipal bonds enter 2023 in much better shape. Yields that began the year at 1% are now far more attractive, in many instances topping 5% on a tax-equivalent basis. The technical backdrop should continue strong, with issuance remaining low due to a decline in refunding opportunities. The outflow cycle that plagued 2022 will likely lose steam in the face of better yields and less tax-loss selling. States are better positioned to withstand the effects of a potential recession, having made prudent use of windfall tax collections to build record reserves. To be sure, challenges still exist. More economically-sensitive sectors will need closer scrutiny and a historically flat yield curve alters the risk/return calculus. But these issues are considerably less difficult to navigate than central banks pinning rates near zero. And we look forward to taking advantage of the gift handed to us by the 2022 market.

For most of the year, we had aggressively pushed out duration, taking advantage of a historic rise in rates that brought significant value back to the market for the first time in years. The shift paid off in the fourth quarter as interest rates plummeted across the curve. Calendar year 2022 will be remembered for the sharp increase in yields that left historic losses in its wake. But we believe some of the moves we executed during the worst of the selloff could have positive ramifications for our client portfolios for years to come. As we turn the corner to 2023, there is sure to be more volatility. We will be ready to adjust our positioning accordingly.