Munis may hit bumps on the Fed's path but should have much to offer in 2022.
The municipal market enters 2022 after a positive year in which combined flows into muni bond mutual funds and ETFs hit a record high of $104 billion. At $464 billion, supply set a record, too, but 25% of issuance was taxable. This supply/demand imbalance propelled tax-exempt munis to strong relative and absolute performance.
This year promises to be more volatile as the Federal Reserve tapers asset purchases and likely raises rates. But the muni market has a history of outperforming Treasuries when the Fed hikes because the tax-free interest that munis pay becomes more attractive as yields rise.
Demand for municipal securities in 2021 was driven by expectations of higher taxes and from excess savings by higher-income households, the traditional buyers of munis. This led to record low valuations (based on the ratio of the yield on a AAA-rated muni security relative to a Treasury bond of equal maturity). While we expect these ratios to rise with the Fed moves, if the policy actions go at a measured pace, munis still should be well positioned relative to Treasuries.
All of this comes against a background of robust credit quality, with low default rates, upgrades exceeding downgrades, strong revenue growth, significant federal support and recovering pension funds bolstering the broad muni market. But this strength continues to be reflected in tight quality and sector spreads.
Yet the reasons most investors have always had for owning munis remain: providing tax-equivalent yields and portfolio diversification. The road might be bumpy at times, but we expect the asset class to deliver reliable income streams and diversification throughout 2022.