Where can muni investors find opportunity?
Tax-exempt muni yields are 35–40 bps higher than where they started the year. The benchmark 10-year AAA yield is back above 1% and trading at the highest level since May 2020. The underperformance we saw over the last two weeks of February sent ratios in the 5-10-20 tenors up 40%, 22%, and 14%, respectively. That historic ratio move gets the market closer to fair value, but by no means does it put munis in the undervalued category—a testament to just how overvalued they were before the sell-off. Ratios are still below five-year averages.
Tax-exempts continue to offer value compared with taxable alternatives for investors in high tax brackets. The prospect of higher taxes, combined with additional fiscal aid supporting state and local government credit, should bolster the demand for tax-exempts throughout 2021 and may result in a persistent shift in ratios.
Comparing value across the A-rated bond market
Source: Bloomberg, 2/26/2021. Tax-adjusted yield assumes a tax rate of 40.08%. Not a recommendation to buy or sell any security.
The bottom line
We view February’s events as a natural and healthy development—reflective of an improving economic landscape but not a marked upshift in inflation. For muni investors, the underperformance has brought back more palatable yields and cheaper valuations. This is good news for long-term investors, since higher rates result in increased income and higher longer-term rates of return.
We favor intermediate and longer maturities given the recent steepening and cheaper valuations on the longer end of the curve. No need to shorten up if you don’t have to. Investors with longer investment horizons should stay the course—avoid realizing gains and reinvesting at yields below 1% on the front end of the curve.
Resilient and improving muni credit fundamentals, combined with additional aid to state and local governments, suggest lower-quality bonds will continue to outperform. Therefore, thoughtful exposure to A and BBB bonds may be advantageous.
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