What a difference a year makes. Following a challenging 2022, the municipal bond market is stabilizing, yet it continues to offer attractive investment opportunities. Industry fund flows have been mixed, but the pace of outflows has slowed considerably since last year. Today we observe a firmer trading tone characterized by improvements in liquidity and the two-way flow of capital. The result is that the market is once again rewarding investors for selecting fundamentally-sound securities based on relative value. Notwithstanding these positive developments, MacKay Municipal Managers remains constructive on the market. In a welcome reprieve for income investors, high grade municipal bond yield levels are at or near their highest levels in a decade. Moreover, municipal income streams are improved from a credit risk-adjusted standpoint. With a market largely comprised of tax-backed state and local debt issuers and essential service providers, we believe municipals are an attractive late-cycle asset class. Many municipal issuers prudently restored their emergency reserves and reduced liabilities following a few years of strong revenue collection. We believe positive credit trends and, for those managers who have taken advantage of the opportunity, the attractiveness of current income streams will continue to anchor the municipal market during the second half of 2023.
Top Five Municipal Market Insights for 2023 – “Preparation Seizes Opportunity – Higher Accruals Set the Pace”
1. Tax-exempt accrual plays a key role in total return
Rationale
Income has regained its prominence in municipal bond total return. Municipal investors can now realize much higher income accruals due to 2022’s sharp rise in rates. Top income tax bracket investors, especially those living in high income tax states, should find the higher tax-exempt income levels attractive on a taxable equivalent basis versus other asset classes. For investors in pooled vehicles, raising accrual rates tends to reward investors who reinvest their dividends through the compounding effect of buying more shares at relatively lower average prices. We believe higher income levels can also better stabilize returns compared to the last several years, when low coupons and yields offered little cushion against price declines. Additionally, we believe investors who remained in passive strategies have missed this opportunity whilehoping the market would recover. Raising accrual rates required actively replacing low book yield positions with much lower priced, higher yielding bonds, trades typically known as tax swaps. We believe investors can benefit from current market accrual rates in 2023 and beyond.
Portfolio in Action
At times during the last year and a half, issuers were periodically forced to issue unusually high coupon bonds (i.e., above 5%) due to market conditions. These structures have rarely been available in the primary market in recent years.
At key inflection points, when others were not as well-positioned to buy, we worked to secure material allotments of these attractively-structured bonds. Higher-coupon securities have helped to increase portfolio accrual rates while decreasing overall interest rate sensitivity.
Higher coupon debt may become harder to source in the primary market, especially at lower prices, as municipal bond industry fund flows come back into equilibrium.
Mid-Year Status
On Target:
- Dividend distribution rates are up, year-over-year. The average actively-managed pooled investment vehicle’s distribution is up by 26% on an asset-weighted basis. We think that investors should give more consideration to those that took the opportunity last year to reposition portfolios and improve income streams. (Source: Morningstar as of 6/30/2023)
- Do not overlook the power of compound returns for those that opt to reinvest. The potential near-term performance benefit of investing in a pooled vehicle with a higher accrual rate may be enhanced over the long run by the compounding effect of buying more shares via dividend reinvestment.
- High grade and high yield municipal bond taxable-equivalent yields of 5.95% and 9.65% compare favorably to the before-tax yields of U.S. Treasuries (4.37%), U.S. high grade corporates (5.48%), and U.S. high yield corporates (8.58%). (Source: Bloomberg as of 6/30/2023)*
3.In a bifurcated high yield municipal market, liquidity drives performance
Rationale
We believe a disciplined pursuit of liquidity will be rewarded in the 2023 high yield municipal market. In 2022, the massive wave of high yield fund redemptions resulted in an equally sized sell-off of bonds as funds sought liquidity. High yield municipal funds primarily sold their more widely held and better quality positions to meet those redemptions resulting in those more liquid bonds underperforming relative to holdings that did not trade throughout the year. In anticipation of a healthier market in 2023, we believe those underperforming bonds now provide the opportunity to outperform as investment discipline re-emerges. In our opinion, discipline in the high yield municipal market goes beyond credit research to include an understanding of liquidity, tradability and the investor base. We expect inflows will return to the high yield municipal market and issuance will be light. As a result, we believe the more liquid part of the high yield municipal market outperforms in 2023.
Portfolio in Action
High yield municipal industry-wide fund flows have yet to return to positive territory and are essentially flat. That said, we still favor the liquid, rated names that came under selling pressure during 2022’s liquidity squeeze. Not only can these securities benefit from eventual positive fund flows as investors buy them back, but their prices also better reflect current economic conditions. The latter point means that this subset could offer less downside risk than less-liquid, lower rated names if generic high yield market spread levels were to widen.
Mid-Year Status
On Target:
- The BBB-rated municipal bond index, considered to be a highly liquid segment, slightly outperformed and returned 4.45% YTD 2023, while the Bloomberg High Yield Municipal Index returned 4.43%. (Source: Bloomberg as of 6/30/2023)***
Within the Bloomberg High Yield Municipal Index, larger, more liquid names were the top drivers of performance.
4.Fund flows drive recovery in long municipal bond prices
Rationale
We believe exposure to longer-term bonds drives return in 2023. Municipal mutual funds and Exchange Traded Funds are the natural buyer of the long end of the municipal curve. We expect a return to positive mutual fund flows results in the outperformance of longer-term bonds. Additionally, mutual funds will likely seek to increase their distribution yields, causing them to extend the maturity and duration profile of purchases. As a result, bond structures with long durations and discount prices enhance return potential relative to shorter duration, premium structures. Finally, the Municipal to Treasury yield ratio curve remains steep, indicating that the longer end of the municipal market offers better value opportunities. Long municipal bonds with Municipal to Treasury yield ratios in the mid 90% range are cheap on a relative basis. We believe portfolios with exposure to longer maturities outperform.
Portfolio in Action
Yield curve positioning has mattered this year. The AAA-rated municipal yield curve is inverted between two and ten years to maturity due to what we see as price-insensitive demand from SMA accounts. This area has offered little in the way of buying opportunities.
Meanwhile, the curve has been persistently steep between ten and thirty years, still indicating that better value can be found in longer-term bonds.
Opportunistic curve positioning will likely continue to drive alpha during the second half of the year.
Mid-Year Status
Pending:
Longer-term municipal bonds outperformed shorter-term municipals through the first half of 2023. The Bloomberg Municipal Long 22+ Year Index returned 4.96%, outpacing the broader Bloomberg Municipal Index, the 1-Year Index, the 3-Year Index, and the 5-Year Index by +2.29%, +1.14%, +0.90%, and +3.77% respectively. (Source: Bloomberg as of 6/30/2023 ****
5.Thinking outside the box – Using short taxable municipals to enhance after-tax performance
Rationale
We believe shorter-term taxable municipal bonds provide better after-tax value than comparable maturity tax-exempt bonds. Investing in shorter term municipal bonds, a tactic used to add liquidity and/or manage duration in a portfolio, becomes more difficult when these bonds are overpriced. In our view, shorter-term tax-exempt bonds have risen in price beyond fair value primarily due to passive investor demand. In 2023, we expect demand for shorter-term tax-exempt bonds to continue unabated and we do not expect that new issuance sufficiently offsets that demand. As a result, we believe shorter-term tax-free Municipal to Treasury yield ratios remain rich through the year. Comparable maturity taxable municipal yields, however, offer better value on an after-tax basis in our view. The taxable municipal market’s continuing expansion, in both size and breadth, has brought a new dimension to relative value trading in the municipal market. We believe investors should favor shorter-term taxable municipal bonds because they provide competitive after-tax yields, attractive spreads to Treasuries and the same high credit quality of the tax-exempt municipal asset class.
Portfolio in Action
Short-term taxable municipal bonds continue to provide benefits. The income advantage remains clear; these high-grade securities offer yields above comparable maturity U.S. Treasury bonds. On the other hand, AAA-rated short-term tax-exempt municipals are trading rich, only offering less than two-thirds of the yield of Treasury bonds.
Also benefitting our positions is the present supply/demand imbalance. Taxable municipal new issue supply has been limited this year, while demand has remained strong.
Mid-Year Status
On Target:
- Short-term taxable municipals, maturing in 1-3 years, returned 1.34% YTD and have so far outperformed comparable maturity tax-exempt municipal bonds, which returned 0.90%. (Source: ICE Data as of 6/30/2023)*****
Shown for illustrative purposes only. Assumes a U.S. taxable investor who pays U.S. Federal income tax rates at the highest current marginal rate of 37.0% and the 3.8% Medicare surcharge tax on income. There are limitations to presenting tax-equivalent yields including, but not limited to (i) they do not show the effect of state and local taxes, which will vary; and (ii) each individual taxpayer may possess unique circ*mstance that could alter the computation of tax-equivalent yields. Thus “tax-equivalent yields” are only intended to represent mathematical illustrations and not actual returns to any investor. Prospective investors cannot rely on this illustration as it is not possible to invest directly in an index, and not every investor would have the same return experience in investable products or strategies. See disclosures at the end of this document for information related to comparisons to an index and index descriptions.
This illustration and nothing herein constitute tax advice. The information contained herein should not be used as a substitute for advice from your tax advisor. Neither MacKay Municipal ManagersTMnor MacKay Shields LLC advise clients on tax matters. Consult your tax advisor for further information.
It is not possible to invest directly in an index. Past performance is not indicative of future results. Please see disclosures for index descriptions.
* Indices: Bloomberg Municipal Bond Index, Bloomberg Municipal High Yield Index, Bloomberg U.S. Corporate Bond Index, Bloomberg U.S. Corporate High Yield Index
**Includes States, Local Governments, Public Power, and Water & Sewer sectors.
*** Indices: Bloomberg Municipal BBB Index (BBB-rated municipal bond index) and Bloomberg High Yield Municipal Index. It is not possible to invest directly in an index. Please see disclosures for index descriptions.
**** Indices: Bloomberg Municipal Long 22+ Year Index, Bloomberg Municipal 1-Year Index, Bloomberg Municipal Long 3-Year Index, Bloomberg Municipal 5-Year Index. It is not possible to invest directly in an index. Please see disclosures for index descriptions.
***** Indices: ICE BofA Broad U.S. Taxable Municipal Securities Index, ICE BofA U.S. Municipal Securities index. It is not possible to invest directly in an index. Please see disclosures for index descriptions.
DISCLOSURES
MacKay Shields LLC does not offer or sponsor any funds registered under the Investment Company Act of 1940, as amended (“Registered Funds”). MacKay Shields LLC serves in the capacity as investment manager of certain Registered Funds through sub-advisory arrangements.
Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes which could affect the market for and value of municipal securities. Such uncertainties could cause increased volatility in the municipal securities market and could negatively impact the Fund’s net asset value and/or the distributions paid by the Fund. Securities purchased by the Fund that are liquid at the time of purchase may subsequently become illiquid due to events relating to the issuer of the securities, market events, economic conditions, or investor perceptions.
Liquidity risk is the risk that certain securities may be difficult or impossible to sell at the time that the seller would like or at the price that the seller believes the security is currently worth. The Fund may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the Fund may be forced to sell securities at an unfavorable time and/or under unfavorable conditions.
Availability of this document and products and services provided by MacKay Shields LLC may be limited by applicable laws and regulations in certain jurisdictions and this document is provided only for persons to whom this document and the products and services of MacKay Shields LLC may otherwise lawfully be issued or made available. None of the products and services provided by MacKay Shields LLC are offered to any person in any jurisdiction where such offering would be contrary to local law or regulation. It does not constitute investment advice and should not be construed as an offer to buy securities. The contents of this document have not been reviewed by any regulatory authority in any jurisdiction. This material contains the opinions of the MacKay Municipal Managers™ team of MacKay Shields LLC but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein 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. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2023, MacKay Shields LLC. All Rights Reserved.
Source Disclosures
ICE Data Indices, LLC (“ICE Data”), is used with permission. ICE® is a registered trademark of ICE Data or its affiliates and BofA® is a registered trademark of Bank of America Corporation licensed by Bank of America Corporation and its affiliates (“BofA”) and may not be used without BofA’s prior written approval. ICE data, its affiliates and their respective third party suppliers disclaim any and all warranties and representations, express and/or implied, including any warranties of merchantability or fitness for a particular purpose or use, including the indices, index data and any data included in, related to, or derived therefrom. Neither ICE data, its affiliates nor their respective third party suppliers shall be subject to any damages or liability with respect to the adequacy, accuracy, timeliness or completeness of the indices or the index data or any component thereof, and the indices and index data and all components thereof are provided on an “as is” basis and your use is at your own risk. ICE data, its affiliates and their respective third party suppliers do not sponsor, endorse, or recommend MacKay Shields LLC, or any of its products or services.
“Bloomberg®”, “Bloomberg Indices®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.
INDEX DESCRIPTIONS
Bloomberg Municipal High Yield Index is an unmanaged index of municipal bonds with the following characteristics: fixed coupon rate, credit rating of Ba1 or lower or non-rated using the middle zating of Moody‘s, S&P, and Fitch, outstanding par value of at least $3 million, and issued as part of a transaction of at least $20 million. Bloomberg U.S. Taxable Municipal Index is a rules-based, market-value-weighted index engineered for the long-term taxable bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies if all three rate the bond: Moody‘s, S&P, Fitch. Bloomberg Municipal Bond Index: a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. Bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two ratings agencies. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date. Bloomberg AAA-, AA-, A-, and BBB-Rated Municipal Bond Indexesare sub-indexes of the Bloomberg Municipal Bond Index. ICE BofA U.S. Taxable Municipal Securities Index tracks the performance of U.S. dollar denominated investment grade taxable municipal securities publicly issued in the U.S. domestic market. ICE BofA Broad U.S. Taxable Municipal Securities Index tracks the performance of U.S. dollar denominated debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. Bloomberg U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers. Bloomberg U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included. Must have at least one year to final maturity regardless of call features. Must have at least $150 million par amount outstanding. Must be rated high-yield (Ba1/BB+ or lower) by at least two of the following ratings agencies: Moody's, S&P, Fitch. Must be fixed rate, although it can carry a coupon that steps up or changes according to a predetermined schedule. Must be dollar-denominated and non-convertible. Must be publicly issued.
