December 8, 2022 | Expert Perspective
Ahead of the curve: Munis prepare for economic uncertainty
In this wide-ranging Q&A discussion, Vanguard portfolio managers Paul Malloy and Mathew Kiselak share insights on the markets, municipal bonds, how to put a challenging 2022 in context, and how muni investors might fare in the current economic environment. Malloy and Kiselak are part of a Vanguard team that manages $233 billion in municipal bond funds.1
Note: This interview was edited for length and clarity.
2022 is shaping up to be a challenging year for municipal investors. What's your take on the current market environment and are we through the worst of it?
Malloy: To think of the conditions of 2022, we should first reflect on what we experienced in 2021, which by all accounts was an exceptional year. Interest rates were low, credit spreads were tight, and the market experienced an incredible rally. What we're seeing in 2022 is really a response to those conditions. COVID-era monetary policy and fiscal stimulus programs are being reversed. What we are going through now is a period of normalization. Interest rate levels are returning to more historical norms.
Kiselak: I agree. The returns we saw in 2021 were not typical. The amount of financial stimulus, the very low rates, the tight credit spreads—that was all a result of an unprecedented global pandemic. It probably wasn't sustainable to think that fixed income markets in general and muni markets in particular would continue to perform at those levels for a prolonged period.
How do you feel about municipal bond valuations relative to other fixed income sectors?
Malloy: Municipal bonds offer some of the best value we've seen in a while, particularly for longer-dated issues. Valuations are close to those of U.S. Treasuries, which means today's investors are getting tax-exempt income at the same level as taxable income. That's also true for some corporate issues. State and local governments are in their best financial shape in a decade. A lot of high-quality issues are available right now at relatively cheap valuations.
Kiselak: On an after-tax basis, investors are receiving equity-like returns; yields are higher than we've seen for the past 10 years. That's a huge positive for income-oriented investors, who constitute a large portion of the muni market. Add in the currently strong muni market fundamentals and the asset class looks very attractive.
Earlier this year, muni managers faced a major outflow cycle. What are your thoughts on where we stand now? When do you think sustained inflows into muni mutual funds will return?
Malloy: In recent years, we saw an exaggeration of both inflows and outflows. We see this mega flow cycle trend beginning in 2017 with the Tax Cuts and Jobs Act, which created a cap on state and local income tax deductions. To recoup the lost tax break, many high-net-worth investors turned to munis. Then some investors exited the market as rates and inflation started to rise. That outflow was the response to the dramatic inflow that preceded it. Despite that movement, munis are best suited as long-term buy-and-hold investments. Long-term investors are generally able to ride out short-term volatility. Dipping in and out of the market can create major missed opportunities for investors.
Muni investors historically sell when yields are most attractive
Kiselak: We've also seen a demographic shift, which has affected muni flows. The U.S. population is trending older. Retirement-age investors are often attracted to the relative stability and income opportunities available in the fixed income markets.
Let's turn toward muni market fundamentals. With the amount of fiscal stimulus given directly to municipalities or collected through taxes, the past few years have given them a great opportunity with excess funds. How has this money been used, and do you believe they are making the most of this opportunity?
Malloy: Federal stimulus monies from the past few years have given state and local governments the opportunity to build rainy day funds, provide funding for pension obligations, and position themselves to weather future downturns. At the same time, property values rose during the pandemic, as did incoming tax receipts. The combination of these two funding sources left many municipalities in better financial shape than they were pre-pandemic.
Kiselak: The big message behind the fiscal stimulus of the past few years is that our federal government supported state and local governments at times of financial stress. That's impactful—combined, the local economies across the U.S. are what make up our national economy.
At the same time, it's a positive for investors when municipalities shore up their balance sheets. Right now we're seeing the highest municipal yields that we've had over the past 10 years. It's a high-quality asset class—more than 85% of the market is rated A or higher, according to Bloomberg indices2—with a strong fundamental risk profile, particularly compared with corporate bonds.
That sounds like a constructive statement overall. What if we experience a recession? How should we expect this market to respond to a 2023 recession, as many predict will occur?
Malloy: A market downturn could lead to some revenue drop-offs, but the current muni market is in a very strong fundamental position. Full coffers can be a buttress against the force of negative economic conditions, should they arise. Munis are much stronger fundamentally than they were in 2008 before the global financial crisis.
Kiselak: Agreed. We just had an extraordinary amount of monetary and fiscal stimulus, unlike anything we've seen. Valuations are now very cheap relative to other fixed income asset classes, so there's less downside risk. Adding in the stability of municipal revenue sources—people pay their taxes and utility bills, even during a down cycle—leads us to view the muni market positively, even with potential economic concerns on the horizon.
Not all municipal bond strategies are the same. What's your approach to investing, and what makes your approach unique or more effective? Have the events of this year changed your strategy, or have they reaffirmed it?
Malloy: The events of the past few years have really reaffirmed our strategy. We're not overly reliant on any one particular approach to generate return from our portfolios. We have credit positions, interest rate positions, and an experienced team with deep knowledge of the space. In addition, because of our low-cost fee structure, we don't have to take on unnecessary risks to overcome the costs of our funds. Instead, we can be selective about when and how we choose to add risk.
Kiselak: We have a diverse and well-staffed team of experts whose skills include trading and execution, portfolio management, and fundamental credit analysis. It's a comprehensive team with a very thorough approach. One of the major tenets of our policy is to avoid forced executions. We take a very opportunistic approach to credit and, at the same time, maintain an adequate level of low-risk and highly liquid reserves.
With all these things in mind, where does Vanguard see the most opportunity in this market? What has been a major focus for the portfolio managers in terms of positioning?
Malloy: Our main focus has been on upgrading the quality of our portfolio and repositioning for the higher interest rate regime we appear to have entered.
Let's sum this all up. How would you frame the overall investment environment for municipal bonds for individuals seeking tax-exempt income?
Kiselak: A benefit of a higher interest rate environment is that it repositions to higher break-evens, or the point where the income the bond generates can offset the price depreciation of a move to higher rates. If you look back to the low point of 2021, rates were very low, so it didn't take much for returns to sink into negative territory. The higher rates we're seeing now create more space—a buffer—between current yields and potential price depreciation.
Malloy: The muni market is as attractive as it has been for decades. Rates are high, and a lot of high-quality credit is available. The market is fundamentally cheap on a relative basis and fairly cheap on a historical basis.
1 As of June 30, 2022.
2 As of August 31, 2022.
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