Municipal and corporate bond markets in 2022 should stay on the solid course charted in 2021. However, keep an eye on potential disruptions and focus on a laddered approach.
The past year saw continued improvement in investment-grade (IG) corporate and municipal credit fundamentals. Economic growth was exceptionally strong and, despite COVID-related disruptions, the economy had exceeded its pre-pandemic size by the middle of year.
By year’s end, the surprising persistence and magnitude of inflation led the Federal Reserve to begin preparing markets for an early end to its quantitative easing (QE) program and for rate hikes, possibly as early as the first half of 2022. Against this backdrop, corporate and municipal valuations were well supported and 10-year yields rose modestly.
Mixed, but strong, performance year
Performance in the two asset classes was mixed. Municipals, as measured by the Bloomberg Municipal Bond Total Return Index, had a solid year, producing a 1.52% total return, while IG corporates, as measured by the ICE BofA/Merrill Lynch 1–10 Year US Corporate Index, returned -0.85%. While both markets were negatively impacted by rising interest rates, municipal bond yields ended the year only slightly higher as strong demand caused the municipal/Treasury yield ratio to decline substantially. In the case of corporates, the improving credit outlook and higher coupons helped the sector outperform Treasury notes with similar maturity by 1.06%—in line with their 25-year average excess return.
Despite shortages of labor and problems with the supply chain, economic growth remained strong. The New York Fed Weekly Economic Index is projecting a nearly 8% increase in gross domestic product (GDP) for 2021. Notably, non-farm payroll growth averaged 582,000 a month and the unemployment rate fell from 6.7% to 4.2%. While this is good news, many companies continue to struggle to find employees. The pandemic appears to have had a significant impact on the labor force, resulting in early retirements and a lower labor participation rate. Therefore, it’s reasonable to expect rising labor costs to be a factor for some time.
The supply chain remains challenging as well. In response to the pandemic, companies cut production and drew down existing inventories. Now, demand is surging—production and transportation companies are struggling to keep pace. Demand for goods has far outpaced existing capacity.
Not surprisingly, price pressures appear to be broadening and, while logistics and supply problems may be cresting, an uncomfortable level of inflation could be with us for some time. The Fed-preferred inflation metric, the Core Personal Consumption Expenditures Price Index, is rising at an annual rate of nearly 5%. While we think inflation will peak in the first half of the new year, we don’t think it will fall back below 2% anytime soon.
The Fed is clearly pivoting its focus from economic growth to fighting inflation. In his first congressional testimony since being renominated in early December, Chairman Powell suggested it was time to abandon the word “transitory” to describe inflation. At its December meeting, the Fed doubled the pace of the taper and modified projections to suggest the possibility of three rate increases in the coming year and three more in 2023.
The pandemic continues to disrupt activity. Late in the year, case counts began rising sharply, suggesting a potential new wave. However, due to rising vaccination rates, new drug therapies, and the growing aversion to lockdowns, we believe that each new wave will be far less disruptive than its predecessors. The Omicron variant may change that calculus, but further epidemiological analysis will be required before we know that with any certainty.
Our outlook for municipal and corporate bonds remains upbeat. Both enter 2022 with solid balance sheets. Municipal finances are much improved compared to their pre-COVID credit metrics. One of the remarkable side effects of the pandemic was that the upper tiers of the tax base, which pay a large share of taxes, simply moved home and continued to work and prosper. As a result, tax receipts improved across all 50 states. The windfall from federal fiscal stimulus and the impact of buoyant equity markets on pension funding ratios also contribute to our constructive outlook for municipal bonds.
IG corporate balance sheets are strong and improving as well. Economic growth has translated to record corporate profits. At the same time, historically low interest rates have allowed IG firms to refinance short-maturity, higher-yielding issues into longer-dated and lower-yielding debt. As a result, corporate issuers have significant financial flexibility and will have less need to raise capital in a rising rate environment. Because of the improving trend in credit fundamentals, rating agencies have upgraded more companies than they’ve downgraded this year.
Based on the low level of corporate spreads and muni/Treasury ratios, near-term returns are likely to be driven by changes in interest rates. While we expect fundamentals to improve in both sectors in 2022, valuations may become more volatile in response to the Fed removing liquidity from the markets.
Granted, there are risks in our view. Two, in particular, stand out. The first is that the Omicron or a new COVID-19 variant could create another significant disruption. The possibility that inflation continues to rise is also concerning, along with the possibility of interest rates moving significantly higher in response. However, we think the case for inflation moderating is a strong one. As the supply chain returns to normal, prices will soften, and the base effects created by the higher index values of the last few months will come into play, raising the bar for future inflation. And it does appear the Fed is finally on the case.
While Treasury yields are widely expected to rise in the coming year, it’s worth remembering that interest rates have proven notoriously difficult to predict. Historically, a bond ladder has proven to be an effective way to generate attractive yields and protect against rising rates or widening spreads. This systematic rules-based approach to portfolio construction reinvests the proceeds of maturing positions into bonds in the longest maturity rung, which offers higher yields as prevailing interest rates rise. In addition, being able to harvest tax losses in such a rate environment has the potential to lower an investor’s overall tax liability, while still allowing them to benefit from higher reinvestment rates.
The bottom line
In 2021, remarkable economic growth was fueled by companies rebuilding depleted inventories and by well-capitalized consumers buoyed by the repeated rounds of fiscal stimulus, pent-up savings, and the twin wealth effects from rising equities and home prices. In 2022, we expect the economy will remain robust despite the threat from rising inflation, tighter monetary policy, and the continued pandemic risks. As a result, we remain optimistic in our outlook for corporate and municipal bonds. Both asset classes have improved their balance sheets significantly over the course of the pandemic. Constructing a bond ladder in a separately managed account may prove an effective way to alleviate concerns over rising rates, as such a structure should produce reinvestment and tax-loss harvesting opportunities.