Municipal Bonds: This Is No Time for Market Timing

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There were no headlines about important developments in the municipal bond market on the front page of the October 27, 2022, edition of The Wall Street Journal. However, something significant did occur on that day: it marked the local peak in municipal bond yields. But this inflection point could not be found in financial news headlines because no one knew at the time—such developments are only clearly glimpsed in the rearview mirror. It would be almost impossible to call the peak in interest rates with any real confidence until weeks or even a month after the fact.

However, there are a few things that we do know now. In the month following the peak in rates in October 2022, the turn (i.e., the reversal to a decline in rates) happened very quickly. From the end of the October to the end of November, municipal yields fell across the curve by roughly 50 to 60 basis points.

Figure 1. What Happened to Muni Yields During the Last Significant Rate Reversal?

Source: Bloomberg. Tenor refers to the time to maturity of a debt issue. Bps = basis points; one basis point equals one one-hundredth of a percentage point.
The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is no guarantee of future results.

We also know that these rate moves translated into strong performance. The municipal market, as represented by the Bloomberg Municipal Bond Index, returned over 4% in the month after the October peak in rates. High yield municipals and longer-duration munis generated even better performance.

Figure 2. Municipal Bonds Posted Strong Returns after the October 2022 Peak in Rates

Source: Bloomberg. The chart depicts returns for the Bloomberg Municipal Bond Index, three maturity-specific segments of that index, and the Bloomberg High Yield Municipal Bond Index.
The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is no guarantee of future results.

The final thing that we can be almost certain of is that investors who waited to be sure that the market turned before reinvesting, did not capture the returns in the far-right column in Figure 2 by April 2023. It is impossible to know that rates have peaked until sometime after the actual top. And as shown in Figure 2, this potentially led to significant opportunity costs as roughly half of the following six-month return starting October 27, 2022, was generated in the first month of the recovery. Considering the mutual fund outflows in November and December of 2022, some investors not only missed the turn, but sold into it.

Today’s Environment

As of the end of October 2023, municipal bond yields eclipsed the October 2022 highs. While no one can be sure where rates may go from here, long-term municipal yields are at their highest level in roughly a decade, and short-term municipal rates are at their highest level since the Global Financial Crisis of 2008–09.

And most important, the yields in today’s environment represent some of the best forward return prospects in recent history. Long maturity AA-rated municipals offer yields of approximately 5%, which translates to over 8% on a tax-equivalent basis. In other words, for long-term investors, high-quality municipal bonds with very minimal default risk are currently showing forward after-tax return potential similar to equities. Historically, this has signaled an attractive entry point.

Figure 3. Today’s Elevated Muni-Bond Yields Signal Opportunity for Investors

Yield on the Bloomberg Municipal Bond Index, November 28, 2008–October 31, 2023

Source: Bloomberg. Data as of October 31, 2023.
The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is no guarantee of future results.

Beyond the attractive forward return potential, today’s elevated yields offer greater protection for investors compared to recent history. This enhanced carry provides cushion for total returns should rates continue to rise, making for a more favorable risk/reward dynamic. In fact, the yield per unit of duration, or investor’s compensation per unit of rate risk, is also at the highest level in 20 years. Put simply, the rise in rates required to turn total returns negative over a one-year period is at its highest level since 2003.

Figure 4. Risk/Reward Dynamic Remains Favorable for Municipal Bonds

Ratio of yield to worst per unit of duration for the Bloomberg Municipal Bond Index, November 28, 2003–October 31, 2023

Source: Bloomberg. Data as of October 31, 2023.
Yield to worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. The Sherman ratio is an interest rate risk measure and represents the yield per unit of duration.
The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is no guarantee of future results.

And these attractive yields come at a time of strong fundamentals for the municipal market. Based on data from Moody’s, municipal credit-rating upgrades continue to notably outpace downgrades. Meanwhile, the “rainy-day” funds held by U.S. states, a key component of their fiscal resilience, are sitting near record levels, based on data from the Pew Charitable Trusts. Although year-over-year growth of tax receipts has dissipated this year, tax collections are coming off a historic base in 2022 and moderating from the extreme growth and stimulus since the pandemic. Of note, second-quarter tax receipts were roughly 14% higher than the five-year average.

Summing Up

The previous peak in rates was only discernible in retrospect. Those investors remaining “on the sidelines” may potentially be facing significant opportunity costs should a turn in interest rates materialize. (Indeed, a report released on November 3 showing slowing U.S. labor-market growth led to a decline in long-term Treasury yields in the day’s trading session.) And with current yields still near multi-year highs, we think investors have a compelling opportunity in terms of both forward return potential and greater protection from future rate increases. History suggests that investors waiting for the market turn will most likely miss out on much of this potential. As famed investor Peter Lynch once noted: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

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About the Author

Nicholas Bragdon

Product Specialist

Nicholas Bragdon is a Product Specialist responsible for covering Lord Abbett’s High Quality Fixed Income and Municipal strategies. In this role, he is responsible for developing investment narratives, marketing materials, and strategic plans for our products across retail and institutional channels.

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Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

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Glossary & Index Definitions

General obligation (GO) bonds are backed by the “full faith and credit” of a government, and are issued by entities such as states, cities, counties, and school districts. Revenue bonds are backed by revenues from a specific projects or facilities (such as toll roads, water/sewer systems, or airports).

Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price. Tax Equivalent Yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond in order to see which bond has a higher applicable yield.

The Bloomberg Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year.

The Bloomberg High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.

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Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

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