2022 was either a year to forget or a year to remember for a very long time, depending on your perspective.
On one side, investors would want to erase from their memory last year’s historically poor market performance, the weakest in decades. Institutional investors would bemoan the massive fund outflows all year long.
On the flip side, research analysts may look back on the year as the best credit environment for municipals in … well, decades.
Technologists may mark the past year as a watershed moment in terms of establishing the foundation for technological innovation in the tax-exempt market.
Market strategists will want to tout the return of fixed-income investments, particularly municipals, as yield levels rose to their most attractive level in at least a decade.
Let’s explore why we call 2022 “the year of the great reset” and what that may mean for our market this year.
Unwinding the pandemic mini-cycle
From a macro standpoint, 2022 basically saw the unwinding of the asset valuation bubble created by easy money by the Federal Reserve and overly stimulative fiscal policy in 2020 and 2021.
Who would have thought that the lockdown would turn into a boon for internet sales and speculative stock trading, that it would upend the existing work and commute model in a way that’s still playing out all around the country?
What started out as defensive recovery measures in response to the COVID-19 outbreak became a massive net stimulus effort.
Just add in the disruptions related to a globalized supply chain and you have the recipe for a significant spike in inflation.
The Fed had no choice but to press the “reset” button and raise rates aggressively for the past three quarters and probably well into the first half of this year.
Municipal issuers clearly did not suffer as much as initially expected from the pandemic. Some even came out in better shape than they were in 2019.
The Pew Research Group estimates the federal government allotted more than $800 billion in pandemic relief aid to state governments, across the six pieces of legislation passed in response to the health crisis.
More importantly, $307 billion consisted of flexible funds that states could use at their discretion.
Admittedly with 20/20 hindsight, this massive federal aid was simply overkill.
Ironically, states and local governments did end up footing some of the bill for the federal largesse, through a much higher cost of capital resulting from the Fed tightening cycle: according to Municipal Market Data (MMD), as of 12/15/22, the yield on 30-year AAA GO paper stood at 3.42%, down from a peak of 4.16% on 10/26 but still 193 basis points higher than where it was on 12/30/21.
Similarly, 10-year AAA GOs were yielding 2.47%, down from 3.41% on 10/26 but 149 basis points higher than at the beginning of the year.
Interestingly, the 1/5 year slope closed at -23bps on December 15th, its highest inversion since MMD was founded in 1981.
It’s not clear whether the municipal curve can predict the next recession like the Treasury curve, but this clearly bears watching.
Historically poor municipal bond performance
According to Barclays, as of the end of November, both the Bloomberg Investment Grade (IG) and Bloomberg High Yield (HY) Indices had their second-worst year since their inception.
The IG Index’s negative return in 2022 was topped only by 1981’s bond market rout and one had to go back to the Great Recession year of 2008 to find a worse performance for the HY Index.
Even after the sharp rebound in November, the Bloomberg U.S. Municipal Index still returned a negative 7.81% as of Dec. 16.
Undone by the combination of curve inversion and rising rates, leveraged funds also took it on the chin, with total returns approaching a very equity-like negative 20-25%.
The Bloomberg U.S. Municipal Index did end the year with a total return of -8.53%. No wonder muni professionals have had to refresh their knowledge of the so-called de minimis rule as applied to market discount bonds (some who are relatively new to our market may find out what that rule is for the very first time).
At the end of the day, last year’s market sell-off sets the stage for a potentially more rewarding 2023, particularly in the second half.
The investment case for high quality municipals is already quite appealing, based on higher tax-equivalent yields and wider quality spreads.
It certainly wasn’t a coincidence that the explosive November rally started when double tax-exempt yields on high grade paper crossed the 4.00% mark, for a taxable equivalent yield in the 6-7% range depending on the state.
There is ground for cautious optimism in the new year.
State and local government credit quality
One of the reasons to stick with high-grade bonds is credit quality.
In a nutshell, state and local governments ended calendar year 2022 (and, for most, the first half of FY 2023) in excellent shape.
More importantly, they also appear to have built up enough fiscal resiliency to withstand a modest recession, should that scenario come to pass.
The Fall 2022 Fiscal Survey of States conducted by the National Association of State Budget Officers (NASBO) reports that FY 2021 and FY 2022 saw historical record highs on several key indicators: (1) annual general fund revenue growth; (2) annual spending growth; and (3) the size of rainy day funds in the aggregate.
According to NASBO, “state revenues performed considerably better than was expected earlier in the pandemic for several reasons. First, federal stimulus measures put a lot of additional money into the economy and directly boosted personal income. Second, personal income taxes were not as impacted as expected due to the recession disproportionately affecting low-income workers while high-income earners were relatively insulated. Third, the pandemic’s effects on economic activity largely curtailed consumption of services that most states do not tax, while consumption of goods, which are taxed, was less affected. Fourth, increased online sales tax collections following the U.S. Supreme Court decision in Wayfair v. South Dakota helped mitigate sales tax losses.”
Most local governments also benefited from the increase in Federal and state aid, particularly large cities, such as Chicago and Los Angeles.
In other words, it really doesn’t get any better than this.
One may even argue this is “peak municipal credit”, as credit conditions may not be quite as rosy going this year.
First, there is the widely forecast recession and much will hinge on the depth and severity of that economic slowdown. Secondly, the market windfall experienced by state retirement plans has largely vanished and unfunded pension liabilities will be back at the forefront of credit concerns.
Finally, it remains to be seen if issuers that used stimulus dollars for current expenditures and tax cuts will experience withdrawal symptoms once federal funds run out.
At the local level, the pandemic did lead to structural changes in work and commuting patterns which will have long-term impact on the tax base of government units which are dependent on property taxes.
Large cities, such as New York and San Francisco, may experience significant reduction in their downtown commercial property assessed valuation.
Incidentally, the stable outlook for the High Grade (HG) sector should give more credence to the argument that HG credits can be monitored by semi-automated credit scoring systems, thus allowing research analysts to spend their time where they’re most needed, i.e., on the lower grade/high yield part of the market.
The data and technology now exist to make that happen.
Potential areas of credit concern
If the 2023 outlook for the investment grade general government sector should be relatively benign, the same cannot be said about certain revenue sectors.
Senior living projects, which accounted for almost 3/4 of all municipal defaults last year, were severely affected by the pandemic and continue to struggle under the twin threat of labor shortages and inflation.
A housing market correction may create headwinds for projects which are still in the startup phase.
Healthcare systems in general may experience withdrawal pains as federal program subsidies run out, even as their operating margins continue to suffer from labor cost inflation, nursing staff shortages and the ongoing tripledemic.
The evolution of the “work-at-home” or “work-from-anywhere” model will also have profound implications on the outlook for mass transit systems and development districts, two very distinct sectors of the market.
Dedicated revenue obligors tied to cyclical revenue sources, such as sales taxes, will require close monitoring if the economy slows down significantly.
ESG reckoning and rationalization
Speaking of sustainable investing, the “ESG” movement in asset management was hit by a regulatory backlash in 2022, one that was arguably overdue.
After jumping on the ESG bandwagon as a new marketing gimmick for fund products, many asset managers were reminded by regulators that the ESG label actually came with serious investment responsibilities, perhaps more than some of them realized.
We view the regulators’ efforts to combat “greenwashing” as a healthy development that will ensure there is substance behind both labeled bonds and labeled fund products.
The “ESG” label also came under fire in the municipal market last year, primarily from issuers in conservative-leaning states or states with significant reliance on fossil fuels.
For our views on how ESG is applicable to the municipal market, please check out our recent article: “Getting Over the ESG Integration Hurdle in U.S. Public Finance.”
As far as we’re concerned, the impact of climate change is a material threat to municipal credit that may or may not reach its tipping point in 2023.
Although the market has yet to penalize or reward municipal issuers based on their climate exposure, this could just be due to the relative lack of data directly linking climate events to tax base deterioration or budget impact.
We believe it’s only a matter of time before such data find wider market acceptance and get reflected in bond pricing.
At least for the time being, we think any ESG strategy (however defined) should have more value as a risk management tool rather than a return enhancement tool.
Toward greater financial transparency?
Away from ESG, one of the potentially impactful developments of the year occurred just a week before Christmas.
As part of the National Defense Authorization Act of 2023, Congress approved the Financial Data Transparency Act (FDTA), which will require state and local governments to standardize their financial reporting in machine-readable format, such as the eXtensible Business Reporting Language (XBRL) currently used by corporate issuers, within the next four years.
The bill was signed by President Biden shortly before the holidays.
Municipal issuer organizations such as the Government Finance Officers Association (GFOA) and sell side trade groups such as the Bond Dealers of America (BDA) lobbied aggressively against the FDTA, calling it both an unfunded federal mandate and a “solution in search of a problem.”
Their efforts did not prevent the passage of the FDTA, however, they were successful in shifting the responsibility for rulemaking from the Municipal Securities Rulemaking Board (MSRB) to the Securities and Exchange Commission (SEC), and in requiring the SEC to scale the standards to reduce the potential burden on small issuers.
Is the FDTA needed? In theory, anything that promotes greater transparency in the municipal market should be a worthwhile endeavor.
As we all know, the biggest knock on municipals as an asset class is the woeful nature of the industry’s disclosure requirements, where financial statements can take up to 18 months or even longer to be filed and disclosure documents are still provided in PDF format.
When it comes to data capture, the reality is much messier, which we know firsthand as data vendors. Much work remains to be done, particularly with auditors as the de facto gatekeepers.
If — and it’s a big if — implemented in a thoughtful way, this potential new legislation does have the potential of standardizing all the disparate reporting formats across the various states, allowing both fiscal analysts and credit analysts to be able to finally compare apples to apples.
For instance, as a power consumer of disclosure data ourselves, we would welcome the ability to find the same data point consistently at a consistent location within the reporting format as opposed to having to look for it all over the financial document.
What the Act does not solve is the timeliness problem in municipal disclosure, which is really the most critical issue to investors.
Given the nature of the budgeting and auditing process in most states, this is not likely to change anytime soon.
Also missing is any requirement to adopt GAAP accounting, which may run into sovereignty issues with the states.
Furthermore, federal mandate notwithstanding, each state may choose to implement the Act to different degrees, potentially defeating the standardization goal of the FDTA.
Last but not least, it remains to be seen whether the SEC as a rule-making body will in fact be more sensitive to issuers’ needs versus the MSRB, our industry’s own self-regulatory body.
Chances are the Commission will turn around and consult with the MSRB anyway.
In 2022, the municipal market basically only had to deal with a single issue: the Fed-engineered steady rise in interest rates.
The new year promises to bring multiple challenges, both positive and negative.
As the rate issue starts to abate, credit concerns will be top of mind once again, but they will be more sector-specific this time around, shaped by the intensity of the upcoming economic slowdown, the still ongoing tripledemic and more fundamental changes to the work model.
For better or worse, the industry’s efforts to support or oppose the newly passed FDTA will re-invigorate discussions around technological adoption and disclosure practices.
Similarly, the short-term backlash against ESG as a marketing ploy should eventually lead to a more thoughtful commitment to ESG as risk management tool and, down the line, ESG as alpha-generating strategy.
Finally, 2023 should see the beginning of the infrastructure financing boom primed by all the recent stimulus legislation. In short, we have the recipe for a very interesting year.