By Ben Barber, CFA, Director, Municipal Bonds, Franklin Templeton Fixed Income
January was a volatile month for markets in general, and municipal bonds were not spared. Ben Barber, Director, Municipal Bonds, Franklin Templeton Fixed Income, discusses the impact of the prospect of rising interest rates on the market and how volatility can create opportunities.
In December 2021, as the market began to price in the Federal Reserve’s planned interest rate hikes in 2022, we saw an increase in Treasury yields – and an increase in volatility. In January 2022, volatility in the municipal bond market accelerated as yields saw their biggest increase since the first quarter of 2021. Price discovery continues to plague the market, as it has over the past month, with bid-ask spreads between 15 and 25 basis points (bp)1 on all expirations on the first day of trading in February.
Much of the larger movement seen in the munis this year has essentially been a catch-up to what happened in the Treasury market late last year, in which the munis did not participate. Munis may continue to experience brief bouts of volatility as price discovery continues in the near term, but longer term, we expect volatility to subside as valuations approach historical norms. When we look at overall market performance it is worse further down the yield curve, but on the quality front yields are pretty much in line across the credit spectrum, confirming that the recent market decline was almost entirely linked to interest rates. .
Despite the current uncertainty, we maintain an optimistic outlook for the remainder of 2022 and remain grounded in our belief that periods of heightened price dislocation create more opportunities to capture relative value. Risk management is at the heart of our portfolio construction process, enabling us to understand exactly how a trade may impact our funds from a time and risk perspective. Over the past two months, our approach to risk management has helped the team maintain a neutral duration profile within our portfolios.
We are able to tap into our deep and experienced research bench and leverage our extensive modeling capabilities to find the bonds that offer the best relative value. While this is true in all markets, we can often find great opportunities when markets are messy, as we saw in January 2022.
The value of Munis
Municipal bonds have traditionally served to reduce the volatility of an investor’s overall portfolio while providing tax-free income. Interest payments on Treasury bonds are subject to an investor’s normal income tax rate. If one wants to get an idea of which asset class is right for them at any given time, they can compare after-tax yields on bonds of equivalent credit quality and maturities in each asset class. The muni-to-treasury ratio is a commonly used measure to perform this exercise; however, it should be noted that Treasury yields are often quoted pre-tax. It is standard practice in munis to assume an income tax rate of 30% when estimating after-tax treasury returns so that an apples-to-apples comparison can be made. From this, it can be deduced that munis are relatively cheap for Treasuries when the muni-to-Treasury ratio exceeds 70%, or relatively expensive when they fall below this threshold – generally speaking.
Over the past 12 months ending January 31, 2022, the average yield on a five-, 10-, and 30-year AAA bond has averaged 54.1%, 68.1%, and 78.5%, respectively, relative to Treasury bond yields at corresponding maturities. .2 As shown in the chart below, AAA muni valuations were generally in line with these levels at the end of last month.
|Munitions-to-cash ratios||5 years||10 years||30 years|
|December 1, 2021||53.60%||75.90%||89.00%|
|Month to month Δ%||-5.90%||-6.40%||-8.10%|
|December 31, 2021||47.60%||69.50%||80.90%|
|Month to month Δ%||30.00%||19.10%||14.00%|
|January 31, 2022||77.60%||88.60%||95.00%|
Navigating Market Conditions: The Importance of Risk Management
Municipal bond market fundamentals remain strong today, while technical data – although slightly weaker lately – looks healthy to us. We believe current valuations provide an attractive entry point for investors who have been sidelined by perceived low nominal yields. The same value exists for investors looking to add to their existing exposure now that munis have depreciated against Treasuries. Therefore, we believe the best chance of active manager outperformance will hinge on credit selection for the remainder of 2022.
We believe that risk management practices will be particularly critical going forward as we navigate looming near-term volatility, whether stemming from political adjustments, pandemic developments or other economic uncertainties. The term “risk management” is often misunderstood to mean the avoidance or mitigation of risk. At Franklin Templeton’s municipal bond team, we believe that periods of heightened price dislocation create more opportunities to capture relative value. In other words, we believe that risk should be optimized rather than minimised. No single measure or methodology can reveal the “truth” about risk.
In our view, a patchwork of analysis, monitoring and consultation protocols are required to gain a comprehensive understanding of risk in today’s municipal bond market. We leverage proprietary credit models, and macro and sector models allow our entire team to assess the relative value of bonds offered in the secondary market, freeing our research analysts to focus on evaluating opportunities of relative value that are available on the primary market. Marlet. Ultimately, the team understands the subtle nuances of credit that are unique to each sector, which in turn enables us to assess the impact of macroeconomic and sector risks on our holdings down to obligor level.
Looking ahead, we are confident in our ability to navigate volatile market conditions and find the right credit stories at attractive valuations for our portfolios.
What are the risks ?
All investments involve risk, including possible loss of capital. The value of investments can go down as well as up, and investors may not get back the full amount invested. Since municipal bonds are sensitive to changes in interest rates, the yield and value of a municipal bond portfolio will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as bond prices in an investment portfolio adjust to rising interest rates, the value of the portfolio may decline. Changes in the credit rating of an obligation, or in the credit rating or financial strength of the issuer, insurer or guarantor of an obligation, may affect the value of the obligation.
1. One basis point is equal to 0.01%.
2. Bloomberg, as of January 31, 2022.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.