What Do Munis, Fed Rate Hikes, and the 80s Have in Common?

The national municipal market is on track for its worst year since 1981. And with the Federal Reserve (Fed) raising short term interest rates at the fastest pace since the 1980s, we think the prospects for an economic recession have increased. What do those two statements have in common? In this edition of the LPL Street View, LPL Fixed Income Strategist Lawrence Gillum explains why we think the worst is behind us for muni securities and how the asset class could be a good place to invest in to weather an economic storm.

Summary:

The Fed is embarking on the most aggressive rate hiking campaign since the 1980s. As such, the risks of an economic slowdown have increased. With inflationary pressures continuing to run hotter than the Fed would like, many Fed officials have stated they are willing to continue to keep increasing interest rates—even to the point of sacrificing economic growth—in order to get aggregate demand and aggregate supply back in balance. The Fed has already raised short-term interest rates by 3.75% this year and they have indicated that more rate hikes are likely. And although the timing of when short term interest rates will peak—and its effect on certain asset classes—is uncertain, the Fed’s tight monetary policy is already having an impact on the most sensitive areas of the economy, such as housing and consumer spending. The Fed has told us and history bears this out that when the Fed raises rates, the economy slows down. The cost of borrowing increases and the incentive to save increases as well. So that tends to translate into less consumer spending. And with less consumer spending, the outlook for corporate borrowers, which are generally those companies that produce the goods and services that consumers purchase—may be challenged in the near term. Muni bonds, however, have proven to be resilient in challenging economic times.

Because of the Fed’s aggressive rate hiking campaign, many fixed income markets are having their worst year in decades. And the normally staid muni market is no exception. To make matters worse though, investors have pulled more than $100 billion from the asset class this year, further pressuring bond prices. The combined effect has been a sharp increase in yields but likely the worst year for muni bonds since 1981. So that’s the bad news. The good news, in our view, is that we think the Fed is getting closer to the end of its rate hiking campaign, which means less interest rate pressures and we’re starting to see inflows back into the asset class, which should help support prices. More importantly though, is that muni’s tend to be a safer alternative than corporate credit during economic slowdowns.

The annual default rate for muni securities is significantly below what has historically occurred in the corporate credit markets. You have to go back to 1983 to see a year in which defaults for muni securities were higher than corporate borrowers. Now importantly, muni defaults during economic contractions have been relatively benign, again, unlike their corporate counterparts. Finally, according to Moody’s Investors Service, a rating agency, the average five-year muni default rate between 1970 and 2020 was just 0.08%, which compares to an average five-year corporate default rate of 6.9% over the same period. Now why is this important? As fixed income investors, it’s common to see negative returns every so often because of changing interest rates—that’s just price volatility. If you continue to hold a bond until maturity, you’ll get your money back at par. Defaults, however, represent a permanent impairment of capital—you’re likely not getting that investment back at par. That is one of the major risks for fixed income investors. And muni securities have tended to have fewer defaults than their corporate counterparts, so the asset class tends to be a good asset class to invest in during economic slowdowns.

Muni bonds are having their best month in decades as signs of these inflationary pressures are easing. Muni debt has gained 4.3% in November—on track for the biggest monthly advance since August 1986. So we are seeing signs that things are improving. Now are we “livin’ on a prayer”? Or do you “gotta have faith” that this trend will continue? We don’t think so. With the influx of pandemic-related stimulus money, healthy tax collections, and prudent savings practices, we think the fundamental back drop for many muni borrowers remains strong. So with the risk of recession increasing, muni securities could be a good area to weather an economic storm. 

You may also be interested in:

• Three Things to Know About Recessions – November 10, 2022
• Could Things Start Looking Up for the Bond Market? – October 27, 2022
• Inflation: An Inside Look at Variables That Could Have an Impact – October 13, 2022