Perspectives

Municipal bonds posted modest losses in the second quarter, following the lead of a Treasury market that finally stopped fighting the Fed. Coming into April, investors were confident that the central bank would be forced to reverse its tightening campaign before year end. But that conviction didn’t last. Economic data stood firm against the torrent of rate hikes, defying predictions for a near-term recession. Regional banks earned back investor confidence, despite a third major failure. And while inflation slowed, it remained well above its 2% target, still threatening to become entrenched. Even when the FOMC stood pat in June, its first pause in 18 months of constant hiking, the committee refused to signal the all-clear, guiding for two more increases in 2023. The street got the message. Short-term rates spiked more than 80 basis points over the quarter while the futures market erased bets that cuts would come later in the year. Long-term rates rose less dramatically, leading the yield curve to nearly match its March inversion, the deepest in over 40 years. An eventual recession is still the market’s base case, but exactly when or how deep remain open questions.

While unable to escape the forces that drove Treasury yields higher, municipal bonds outperformed the broader market, thanks mostly to a strong technical environment in June. New issue supply continued to slow, with second quarter origination down 16% from the same period in 2022. Even so, municipal bonds struggled in April and especially May, due to expensive relative valuations versus Treasuries and concerns that more regional banks could have their municipal bond portfolios seized and forcibly liquidated by government regulators. Neither of those issues derailed the market, however, as municipal bonds steadily cheapened and the banking turmoil eventually settled down. By June, retail investors were flush with cash from seasonally-high rollover flows and eager to lock in higher yields and cheaper ratios. While supply was still modest, there was enough variety to lure a broad range of demand, which provided the price discovery necessary to sustain the positive momentum. The SVB/Signature Bank portfolio was liquidated by the FDIC in an orderly fashion, ultimately proving of little consequence to overall sentiment. Municipal bonds posted solid gains to end the month even as the Treasury market limped into quarter end.

Higher rates in the second quarter offered better market entry points. With the municipal curve’s lowest point of inversion located in the seven-to-nine-year maturity range, the best buying opportunities were found out past 10 years, where the curve was not only upward sloping, but steeper than its historical average. Ultimately, the problem with biting on short-term debt is that if you get the timing wrong and rates drop over your holding period, you’ve wasted a valuable opportunity to generate income over a longer haul.  At this point in the economic cycle, that risk is particularly acute.

The prospects for municipal bonds entering the third quarter are encouraging. More attractive tax-equivalent yields are stoking demand just as the tailwinds from the summer technical environment are about to strengthen. In fact, over the next two months, coupon and maturity redemptions are scheduled to outpace issuance by close to $30 billion, creating a net negative supply dynamic capable of powering summer returns. Fundamentals remain solid. Most states begin the 2024 fiscal year expecting a normalization of tax revenues from the sky-high levels of the pandemic era. Forward looking budgets have anticipated a slowdown in growth, weaker capital gains and the end to the federal relief windfall. If events prove worse than forecast, record high rainy-day funds, built on years of surpluses, stand ready to bridge any gaps. One area of caution is valuation. The outperformance in June pushed ratios back toward historical tights, but if there were ever a time to pay a premium for municipal bonds relative to the rest of the fixed income space, it’s hard to imagine a scenario that better aligns fundamentals with technicals, especially entering a period that may shower favor on high-quality asset classes with a reputation for stability.