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What is in Store for Municipal Bonds in 2023?

Municipal bonds are a staple of many investment portfolios, especially for investors in higher tax brackets. The tax-exempt nature of muni bonds helps boost after-tax returns while providing a high level of safety. But like the rest of the financial markets, muni bonds saw a historic drop in 2022, thanks to rising inflation and interest rates.

Let’s take a look at how the municipal bond market performed last year and what’s in store for 2023 and beyond.

Be sure to check our Municipal Bonds Channel to stay up to date with the latest trends in municipal financing.

A Bloodbath in 2022

Many investors hold municipal bonds as a safe-haven investment class, but it was far from safe in 2022.

Municipal bonds lost about 8.5% of their value over the past year, marking their worst performance since 1981. While that’s better than the S&P 500’s 18% drop and the 12% decline in Treasuries, it’s a substantial drop for an asset class known for its even-keeled performance.

The drop came after the Federal Reserve pushed interest rates to their highest levels since the 2008 financial crisis. In response to rising interest rates, fund managers sold bonds and exacerbated the price decline, creating significant discounts across the market.

At the same time, fewer issuers sold new muni bonds in 2022. According to Refinitiv data, total issuances fell about 22%, although most of the decline came from a roughly 50% drop in refinancings. And higher interest rates suggest new issuances will continue to be sluggish in 2023.

Will the Market Recover?

The outlook for muni bonds in 2023 depends on several factors, including interest rates and government finances.

Currently, interest rates stand at a 425-450 basis point range following the December meeting. And according to the CME FedWatch, interest rates have a nearly 75% chance of hitting a 475-500 basis point range by March and a more than 25% chance of rising to a 500-525 range in May.

Government finances also look shaky going into 2023. For example, a recession could hurt tax collection, and hard-hit state and local pension funds could drain working capital. And a Citigroup report suggests downgrades will exceed upgrades in 2023.

That said, historic drops in the muni bond market saw significant rebounds during the following years. For example, robust 40% gains followed the 10% correction in 1981. But, of course, as all investors know, past performance is no guarantee of future results.

How to Position Your Portfolio

The muni bond market may face plenty of obstacles in 2023, but that doesn’t mean there aren’t opportunities.

The apparent economic slowdown in 2023 means investors should seek higher quality issues in stable sectors, such as general obligation bonds, water and sewer, and transportation-related revenue bonds, according to Commerce Trust’s Brian Musielak, CFA.

Investors may want to look at tax-equivalent yields to find opportunities when looking for bonds in these areas. For instance, long-dated muni bonds offer substantially higher tax-equivalent yields to Treasuries. And they may even be attractive alternatives to some corporate bonds.

Finally, it’s worth noting muni bonds could provide valuable diversification. In particular, they could help hedge against a decline in equity markets, which could become increasingly likely with the odds of a recession on the rise over the coming months.

Don’t forget to check our Muni Bond Screener.

The Bottom Line

Municipal bonds had a rough year in 2022, but investors are cautiously optimistic that 2023 won’t be as bad. With a potential recession and rising interest rates in the cards for 2023, investors may want to seek out high-quality issuers with attractive tax-equivalent yields.

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Jan 25, 2023