The municipal market is a safe haven with stronger fundamentals and higher quality than the corporate market, as well as buying opportunities, according to Jennifer Johnston, director of research in the municipal bond group at Franklin Templeton.

“We have significantly lower default rates and the ratings of the muni indices are even stronger when compared to the corporate bond market indices,” she said of the municipal market last week in a webinar: “Navigating Rates and Risks: Will 2023 Be Bonds’ Comeback Year?”

She was joined by Tracy Chen, portfolio manager at Brandywine Global and Annabel Rudebeck, head of non-U.S. credit at Western Asset Management Company, who also shared their views on the taxable bond market.

Overall, the municipal market is “extremely” inefficient and Johnston said investors can take advantage of current market dislocations for value. “When there are market dislocations, like we are seeing now, it gives us an opportunity take advantage of that and find good value.”

“We generally see stronger credit fundamentals in our market, and we do see some opportunities, particularly going out long, where munis are still relatively cheap versus Treasuries compared to where they’ve been in the past,” Johnston added.

In addition, she said municipals are currently participating in a flight to quality supporting Treasuries. 

“Munis don’t always move in lockstep with Treasuries — we tend to lag a little bit — but hopefully, over time, the flight to quality can benefit munis,” she said.

Switching to the economic front, there definitely are positives and negatives to municipal credit quality when dealing with inflation, Johnston added.

Governments experience inflation just like consumers do, she explained. “When costs go up, it can erode operating margins, which can require budget adjustments,” and impact cost to borrow. 

The municipal market provides a significant amount of infrastructure for the U.S., so it is a capital-intensive sector, she noted.

“We think some of the pressure coming from higher borrowing costs is mitigated by some of the decisions made during the COVID recovery,” she added. “Municipal entities benefited from federal aid and economic stimulus, which translated into surpluses. Some entities used part of their surplus to pre-pay debt and cash fund capital projects,” which is helping to reduce the need to issue debt.

Another “interesting” impact she identified from rising costs is on the labor side. 

“It’s impacting pretty much every sector, but more so in the healthcare and senior living sectors,” which are paying more for their employees, and that is putting pressure on their margins, she said. 

“This can impact many areas of spending, particularly for state and local governments because, as wages go up, so do the entities’ required contributions into pension funds,” Johnston said.

On the flipside, there is a positive aspect to inflation for municipal governments and many transit agencies, where income taxes and sales taxes often make up a meaningful part of revenues, according to Johnston.

“As wages go up, so do income taxes, and as the cost of goods goes up, so do sales taxes,” she said, noting the strong budget performance across the past several years was driven by these revenue sources.

“Through the end of 2022 and the beginning of fiscal 2023, we’ve seen really strong revenue performance,” Johnston said. “We expect that to continue until consumers start to make different purchasing decisions because costs are higher or wage inflation starts to moderate.”

She is starting to see growth rates slow, which should continue into next fiscal year.

Meanwhile, the recent banking sector troubles have not had very much of an impact on the municipal market, Johnston explained. 

“The first concern when the crisis started was whether or not pension funds had exposure to any of the banks, either from a debt or equity perspective,” she said.

“We have seen some exposure, but generally these are very diversified investment vehicles, so we do not expect any long-term pressure on public-sector pensions,” Johnston said.

Banks own about 15% of the municipal market, according to Johnston, and  they tend to own high-grade, long duration bonds. “For collateral purposes, the banks could see advantages to holding Treasuries and agency notes and selling the municipal bond components of their portfolio,” she said. 

“That’s something we’re looking for — whether or not banks have to sell,” she said.

Johnston said she is monitoring the collapse of Silicon Valley Bank and Signature Bank for potential impacts to the municipal market, including how it will affect the ownership of municipal bonds by banks, which hold a significant amount of bond debt.

“I think the market is trying to prepare itself for that,” she said.

Looking ahead at the third quarter, Johnston said the municipal market should be in good shape.

“Assuming the banking challenges are contained and Fed actions keep inflation in check, we would expect market volatility will lessen,” Johnston told The Bond Buyer after the webinar.

“On the fundamental side, we think the strong revenue growth we have seen over the past year will slow, pressuring operations,” she continued. “Muni entities will likely implement austerity measures or tap the strong reserve funds they built over the past several years.”

As a result, Johnston believes spreads could tighten in the investment grade space.

“I see municipal bonds as currently being a great value,” she said. “The fact that they generate tax-exempt income is certainly important for many investors,” she said.

Currently the firm is taking advantage of the market dislocations and inefficiencies and is keeping an eye out for opportunities for value — especially further out the curve, according to Johnston.