Although several factors tend to drive municipal security valuations, a policy-induced catalyst for market volatility in 2022 could impact the preference of retail municipal bond investors (who represent majority ownership of the municipal bond market) and cause dramatic swings in valuations.
On monetary policy, the US Federal Reserve (Fed) remains under pressure as inflation accelerates and the timing of rate policy intervention is debated. Fixed income investor anxiety remains high, prompted by worries of higher inflation, increased rate volatility, and/or a potential misstep in Fed policy. Each instance could negatively impact fixed income returns. Encouragingly, though, historical analysis can reassure market participants that municipals have outperformed in rising-rate environments with lower volatility.
On fiscal Policy, the surprise exclusion of several municipal market provisions in the Presidential administration’s Build Back Better (BBB) plan gave pause to the 2021 (to November) rally in municipals. With several proposed tax changes irresolute, conclusive supply-demand implications for municipals have yet to be defined.
Raising or eliminating the state and local tax (SALT) deduction cap has the potential to negatively impact demand for tax-exempt municipals. Notwithstanding, we believe retail demand should remain resilient and the institution of a minimum in the corporate tax rate could supplement demand from banks and insurance companies.
Despite volatility potential, instances of market dislocation tend to be short-lived and could present attractive buying opportunities. Municipal bond yields, which typically exhibit lower volatility traits compared to other fixed income asset classes, may offer some defensiveness amid a distinct supportive technical and fundamental backdrop in 2022.
The municipal bond team, Insight Investment.
Doc ID: 819929