As investors worry about the repayment ability and credit quality of corporate bonds during a slowing economy, Jeff Burger, portfolio manager at BNY Mellon IM, believes that municipal bonds offer greater resilience than their corporate peers.
“Fundamental credit conditions remain solid for most state and local municipal issuers. Most states ended fiscal year 2022 with both year-over-year revenue growth and revenues exceeding forecast,” said Burger in an interview with FSA.
Following declines in fiscal year 2020, the year 2022 marked the second consecutive year in which states experienced rapid growth in tax collections.
As many states report their largest surpluses in history, Burger noted that states have begun examining the best use of these proceeds, such as further increasing the size of rainy day funds, providing tax relief, paying down long-term debt, making additional investments in areas including education and infrastructure and rolling over part of the surplus to fiscal year 2023.
These provisions taken by states have prepared them for any future slowdown in tax collections, he added.
Meanwhile, corporate bonds are likely to be at risk with the possibilities of a US recession increasing as the Fed will have to continue to increase interest rates, Burger noted.
Many US municipal bonds exempt US domiciled investors from federal income tax and sometimes even state taxes, which makes them popular among US investors.
Although, Burger noted that overseas investors are one of the fastest growing segments of demand in the municipal bond market and they tend to prefer taxable instruments.
“Taxable municipal bonds generally trade with a higher gross yield than their tax-exempt counterparts and this has led to an increase in demand from non-US investors,” said Burger.
According to the Federal Reserve Board, at the end of 2021, foreign investors now own more than $100bn of municipal bonds compared with less than $80bn a decade ago.
Burger also noted that municipal bonds have a lower default risk than corporate debt.
According to Moody’s, municipal bonds are mostly concentrated in the investment grade space, whereas credit ratings for corporate bonds are distributed across both investment grade and high yield.
Burger also noted that in the case of default, US municipal bonds have a recovery rate of 68%, whereas global corporate bonds have a recovery rate of 47%.
Against a backdrop of widening credit spreads and a heightened risk of a recession, BNY Mellon is maintaining a defensive approach, which includes a bias towards essential service revenue bonds, such as electricity, water, sewage treatment and waste disposal.
“We continue to see opportunities in travel-related credits, for example, airports and toll roads, which have seen volumes recover to near-pandemic highs due to pent-up demand,” he said.
Meanwhile, Burger said the healthcare sector overall remains challenged with labour shortages and rising labour costs, although he believes the stronger credits should continue to perform well.
Burger manages the BNY Mellon US Municipal Infrastructure Debt Fund, which has been made available to Hong Kong and Singaporean retail investors since February 2020.
The $805.5m fund mostly invests in investment grade municipal bonds, with 19.2% of its net asset value allocated to the special tax sector, 11.7% to transportation, 11.0% to education and 10.3% to airports.