The changing face of Baa rated munis
With the upgrades to New Jersey in the third quarter of 2022 and Illinois in the first quarter of 2023, the size of the Baa Muni Index has fallen to its lowest levels in almost 7 years.* This migration of two large state obligors up from the lowest rung of investment grade credit doesn’t materially impact the overall muni market, however, we would argue that it does have risk implications for investors looking to move down in credit quality in their search for additional yield.
The composition of the Bloomberg Baa Municipal Bond Index has become top heavy, with the City of Chicago and the Metropolitan Pier & Exposition Authority (two below investment grade credits not long ago) representing more than 10% of the Index on a combined basis. These are two of the most volatile credits in the municipal market, with Chicago facing a budget deficit of more than $300 million this year and Met Pier debt service payments being made upon annual appropriation by the Illinois legislature. Additionally, the percentage of securities in the Baa Index that pay interest subject to the alternative minimum tax (AMT) is closing in on 20%; while the 2017 Tax Cuts and Jobs Act (TCJA) suspended the AMT for individual taxpayers, that suspension will sunset in 2026 which means the universe of available Baa names becomes even smaller for tax sensitive investors.
Bloomberg Baa Muni Index as % of All Muni Index*
Sources: Schwab Asset Management®; Bloomberg; data from 12/30/22 to 9/14/2023. Corporate bond spreads represented by U.S. corporate BBB-rated bond yields minus 10-year Treasury yields. Agency MBS spreads represented by the Morgan Stanley 30-year Conventional Current Coupon ($100) OAS Indicator.
Our strategic, credit-focused SMAs have been targeting an active overweight to Baa rated credit. However, given recent upgrades across our portfolios (New Jersey and CommonSpirit Health, in particular) and the resulting decline in suitable Baa names in the market, we are content to approach this rating cohort with more of a market-neutral weight as the economic picture continues to develop.