Asset Class Spotlight Municipal Bond Outlook 2023

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  • 03 mins 28 secs
Megan Poplowski, Fixed Income Portfolio Manager and Director of Municipal research, gives her view on the Municipal Bond landscape for 2023.
Channel: MFS Investment Management

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Hello, I’m Megan Poplowski, Portfolio Manager and Director of Municipal Research at MFS.  I wanted to share our views on the Municipal Bond Market as we close out 2022 and head into the new year.

Without a doubt, 2022 has been a tough year for municipal bonds. The US Federal Reserve’s aggressive tightening campaign, coupled with record industry-wide retail outflows, has resulted in the worst downturn in the market in in 40 years. While conditions have begun to improve late in the year, calendar year returns for 2022 may well go down as among the worst annual returns on record. To put this in context, since 1980, there have only been five previous calendar years with negative returns. 

However, it’s not all doom and gloom! Investment grade municipal bonds have never experienced back-to-back negative calendar years, and historically municipal bonds have delivered attractive returns after periods of outflows.

We expect the Fed to remain committed to hiking rates to bring down persistently elevated inflation.  Hawkish policy, coupled with the market’s efforts to divine the Fed’s path, will likely keep rate volatility elevated in the near term.  Given this environment, we believe outflow pressure and choppy performance is likely to persist for the asset class in the near term.

In our view, there are three key reasons for optimism here. 

1. Valuations:   Income has been the largest component of fixed income total return, and historically higher starting yields have been strongly correlated with higher future returns. Additionally, given reset yields from higher-quality investment-grade municipal bonds, investors may not have to take on more credit risk to achieve their desired income needs, as they have in the past.

2.  Fundamentals: Municipal borrowers are generally in strong financial positions. Healthy tax collections and high property valuations should buffer state and local governments against economic softening. The normalization of economic activity supports revenue-backed sectors including airports, toll roads and higher education, while the health care sector should benefit from efforts to contain inflation. All told, we believe upgrades will likely continue to outpace downgrades, and default rates should remain low. 

3.  Resiliency:  Although we acknowledge that the economic outlook is uncertain, investment-grade municipal bonds have been relatively resilient during recessionary periods.

Over the past four US recessions, investment-grade municipal bonds have returned on average 2.0% during the recession, 8.4% during the 1-year period following the recession and 10.6% during the entire period.

Looking into 2023, we expect growth and inflation will moderate, resulting in a decline in rates and the eventual return of stability to the asset class. We believe duration may once again add value, and as such we have modestly extended duration.  Higher yields have provided risk compensation for some lower quality bonds that we believe can withstand slower growth next year. We continue to actively select securities that our analyst team believes offer an attractive combination of yield and quality, including single family housing, education, and health care.

Thank you for your time.

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