David Hammer: 2022 has been a challenging year for muni investors. Supply-side disruptions and surging commodity prices have caused inflation to remain stubbornly high. The Federal Reserve is raising rates faster than initially expected, and the US muni market is in the midst of one of the largest outflow cycles ever.
Sharp outflow cycles have historically signaled buying opportunities, as valuations need to cheapen to draw in new buyers. We see an opportunity in munis today for US taxpayers for a number of reasons.
First, valuations are historically attractive versus taxable fixed income. 10-year munis have cheapened from trading at about 65% of US Treasuries at the beginning of the year to as much as 100%, before settling in recently at about 85%.
Tax-exempt munis have also cheapened relative to taxable corporate bonds.
And absolute yields have risen significantly as well. 5yr munis at 2.25-2.50%, tax-free, are near the highs of the last decade.
Secondly, credit fundamentals are largely improving across state and local governments, as we discussed in our most recent “Munis in Focus” outlook.
For example, the state of California has a record budget surplus of $98 billion. And the State of Illinois was upgraded recently for the first time in 25 years.
At the local level, property taxes make up a large percentage of revenues collected by local governments. Home prices have appreciated by 10-15% in many areas over the last year, and this will be a tailwind for local government credit in the years ahead.
Lastly, as the pace of monetary policy tightening has increased, recession probabilities are rising – we are looking at our portfolios increasingly through a late-cycle lens. And we tend to favor tax-exempt munis late-cycle, for a few different reasons.
Number one, they have lower default rates than investment-grade or high-yield corporate bonds, lower correlations to equities, and tax-exempt munis have historically outperformed taxable fixed income during Fed hiking cycles.
As an active manager here at PIMCO, we are seeing a wide variety of attractive opportunities in the muni market lately.
We’ve seen opportunities in the utility sector to purchase investment-grade tax-exempt bonds that are trading at higher yields than where taxable debt backed by the same issuer is trading. Prepay gas bonds backed by US financial institutions are trading at a tax-free yield of 3.50-4% in 5-10yrs – that’s a taxable equivalent yield of about 6%, which is higher than where parity taxable risk trades.
We are focused on smaller local government issuers with improving credit fundamentals that offer a yield pick-up versus larger, more well-known issues.
And then lastly, we are finding opportunities in single-name credits that actually benefit from inflation, such as multifamily housing projects that tap the muni market to finance affordable or workforce housing.
In short, with higher yields, cheaper valuations, and wider credit spreads compared with the start of the year, muni bonds offer a particularly attractive opportunity today for those seeking a tax-efficient way to invest late-cycle, without sacrificing on credit quality.
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax.
The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.
The issuers referenced are examples of issuers PIMCO considers to be well known and that may fall into the stated sectors. References to specific issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold securities of those issuers. PIMCO products and strategies may or may not include the securities of the issuers referenced and, if such securities are included, no representation is being made that such securities will continue to be included.
The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
Taxable-equivalents yields assume a flat tax rate of 40.8% for a combination of federal, state, and local tax rates. This analysis does not take into account all tax considerations.
PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022, PIMCO.
Copyright PIMCO 2022. All Rights Reserved. Investment Products: NOT FDIC INSURED | MAY LOSE VALUE | NOT BANK GUARANTEED.
PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022 PIMCO
Pacific Investment Management Company LLC (“PIMCO”) is an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”). PIMCO Investments LLC (“PIMCO Investments”) is a broker-dealer registered with the SEC and member of the Financial Industry Regulatory Authority, Inc. (“FINRA”). PIMCO and PIMCO Investments is solely responsible for its content. PIMCO Investments is the distributor of PIMCO investment products, and any PIMCO Content relating to those investment products is the sole responsibility of PIMCO Investments.
The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as none of PIMCO nor any of its affiliates is undertaking to provide investment advice, act as an adviser to any plan or entity subject to the Employee Retirement Income Security Act of 1974, as amended, individual retirement account or individual retirement annuity, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other fiduciary unrelated to PIMCO about whether any given investment idea, strategy, product or service described herein may be appropriate for your circumstances.
Check the background of this firm on FINRA’s BrokerCheck.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.