The Municipal Market Looks Darkest Before the Dawn

Bond market investors were battered by rising rates during the first three quarters of the year. And because the rate rise began from such historically low levels, coupon income provided only a thin cushion to offset the ensuing price declines. As a result, the investment grade municipal market registered its worst nine-month performance since 1981 and the worst consecutive 36-month performance on record.[i] Now that prices have dropped and yields have risen, our analysis suggests that downside risk has decreased and upside return potential has increased markedly.

Framing our expectations for the medium term

We looked at the Bloomberg Municipal Bond Index[ii] to answer a key question: how does the municipal market typically perform after a 12-month period of negative return?

We learned that over the nearly 42-year history of the index, municipals generated negative 12-month total returns roughly 12% of the time.[iii] For each period of negative 12-month return, the average forward 12-month return exceeded 13%.[iv]

The bulk of the cycle may be behind us

In our view, the relationship between periods of negative trailing returns and positive 12-month forward returns indicates the potential upside to come after this year’s bond market selloff. High-quality bonds tend to exhibit mean-reverting characteristics. When returns have been deeply negative, the market at some juncture has typically reversed course.

While we are not forecasting an imminent reversal in the municipal market, we believe the bulk of this interest rate cycle is behind us. In our view, today’s higher yields can potentially provide investors with downside protection against further rate increases and, if history is any indication, potential upside.

[i] Source: Bloomberg, as of 30 September 2022.

[ii] The Bloomberg Municipal Bond Index is the broadest measure of the investment grade municipal market with the longest history of returns (dating back to 1980).

[iii] Source: Bloomberg, as of 30 September 2022. The Bloomberg Municipal Bond Index generated negative 12-month rolling returns 60 times out of 502 months. Source: Bloomberg, as of 30 September 2022.

[iv] Source: Bloomberg, as of 30 September 2022. Forward return analysis excluded the negative return periods in 2022, as forward 12-month return data for these periods is not yet available.

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