Jason Mertz: Daryl, we just wrapped up 2022. It was a really, really challenging year for fixed-income investors, and the municipal market certainly was susceptible to that. We are battling not only really, really high inflation, but a very, very aggressive Federal Reserve and the way that they were tightening the short end of the yield curve in interest rates. Talk us through how these dynamics played out in the muni market and what happened in 2022.
Daryl Clements: No one expected, not even the Fed, the amount of increases that they put through, but nevertheless, that’s what happened. More specific to the municipal market, though, it was municipals [that] were expensive. They had a really good 2021 coming into 2022, at least relative to Treasuries, and they became expensive. So municipals had to give back a little bit at some point, and the market and we expected that to happen, and it did, especially early in the year.
And then finally, it was outflows. The municipal market realized over $120 billion in mutual fund outflows, by far a record. All three of those issues combined caused the muni market to have its worst year since 1981. So there was a lot of activity in portfolios, which clients should expect in a year that we haven’t seen in over 30.
JM: In addition to all those moves that we made throughout the year, I know we did an enormous amount of tax loss harvesting throughout 2022. We take a somewhat different approach to tax-managing accounts. Could you walk us through our process a little bit for that?
DC: Well, we use technology for that. We do it in a systematic way, and we use what we call our AbbieOptimizer to scan our portfolios and identify losses across our platform. And throughout the year, we’ve sold nearly $12 billion in bonds to take advantage of losses, because that is valuable to an investor. Not only can they take that loss, offset a gain this year or sometime in the future, but they can also increase the book yield of the portfolio [and] earn more income on the portfolio.
JM: In the fourth quarter, we started to see some strength, and that’s really carrying us into what we expect and what we’re looking forward to in 2023. We still have the Fed scheduled to raise rates in the first quarter. Walk us through what else we expect to play out in 2023.
DC: Well, I think it’s the year bonds likely return to normal. And what I mean by normal is income. The broad municipal benchmark had a yield of 1.11 at the beginning of 2022, end of the year at 3.55. In fact, it was over 4 at one point. So you finally have income back in fixed income. And I agree with you that the Fed will likely continue to move higher. That will create some choppiness in the beginning of the year in the first quarter. But then after that, we do expect inflation to moderate, continue to moderate, [and] the economy to begin slowing. And with that, the Fed likely pauses and eventually pivots.
JM: How are we positioned, and what’s our expectation for how portfolios should return in 2023?
DC: We like duration, so we’re duration neutral. We do like being in a barbell structure, because when the Fed does pause and then eventually pivots, those long bond yields should fall and they’ll gain a lot in value. We like credit. Again, those spreads are wide. We want credit in portfolios today, especially given the fact that you have credit fundamentals that are as strong as they’ve ever been. And we all know one of the benefits of municipal bonds is they rarely, rarely default. And then finally, today, we want Treasuries in portfolios where we can, because municipals had a really good run at the end of the year, and they became a little bit expensive relative to Treasuries, especially on the shorter end of the yield curve.
So to try to tamp down some of that potential risk, if you will, of municipals moving back to fair value, we would like and want to own some Treasuries on the shorter end of the yield curve. We probably won’t be there for long as the market continues to move, but right now that’s how we’re positioned.
JM: How would we expect municipalities to fare in a recessionary environment, from a credit quality perspective?
DC: Well, if we do run into a recession, which is probably likely, it’s likely to be a modest recession, though. And in that type of recessionary environment, credit should be contributing to performance. It will hold its value. Given where yields and spreads are, we would expect municipal bonds or credit to hold its value fairly well.
I think it’s incumbent upon every investor to demand that their managers have flexibility. I really do believe that’s important in this environment, because there’s still uncertainty. No matter what the market believes [or] what we believe, there’s still uncertainty out there. So having a certain level of flexibility to navigate this environment is critical.