Perspectives

Municipal bonds posted moderate losses in the first quarter but weathered an even deeper selloff in Treasuries. Tax-exempt yields rose 20-25 basis points across most of the curve, 10-15 basis points less than what we saw in the broader market. The outperformance was driven by strong demand for tax-exempt income, which neither a surge in supply nor stretched relative value ratios could deter. It helped that the turn of the calendar brought with it a major slowdown in tax-loss selling, as investors shifted their attention to the availability of historically elevated tax-equivalent yields. Mutual fund flows turned positive while money poured into separately managed accounts (SMAs). And though the new issue calendar was up 24% from first quarter 2023, total volume ($100 billion) was in line with the prior three quarters and proved manageable. Remember, in the municipal bond market, elevated supply is often supportive because new issue scales provide much-needed price transparency. The short end of the municipal bond curve lagged the rest of the pack, enduring heavy selling pressure toward the end of March, likely to help pay upcoming tax bills.

At the macro level, Treasuries were forced to give back some of their fourth quarter gains after a raft of fresh economic indicators led investors to reassess the timing and magnitude of an assumed Fed pivot. Back in December, the futures market had penciled in six rate cuts for 2024, with the first expected to occur in March. But surprisingly strong readings on growth, employment and inflation led traders to pare those bets and push back their timetable. The biggest market mover was the January payrolls report, released in early February, which showed a surge in new jobs at the same time wages were increasing at the fastest pace in two years. Meanwhile, the sharp fall in inflation that had been in place over the second half of 2023, saw a bit of a reversal, particularly in core services, which is proving stickier than expected and posing a threat to achieving the “last mile” toward the Fed’s 2% target. While officials conceded that the data introduced more uncertainty to their outlook, they only slightly altered their forecasts for policy, expressing confidence that the long run picture for price stability was still on track.

Activity

We were fairly active in the first quarter, taking advantage of the increase in yields to find attractive entry points. One aspect of the supply calendar that offered value was the high number of megadeals (over $1 billion), which often have more difficulty clearing the street. And because many of those were issued by borrowers who frequently tap the market, most were priced to compensate for any negative effects on demand from market saturation. Those dynamics led to dealer concessions, which in many cases, helped cheapen smaller, competing offerings. We were able to source bonds at attractive levels across a variety of names, ratings’ categories, and sectors. Structurally, we continued to focus our sales at the front end of the curve while deploying the proceeds in the 10-20 year range, which still offers the most return potential in terms of yield, spread and roll.

Outlook

Municipal bonds begin the second quarter in excellent shape, with yields at year-to-date highs, credit spreads in fair value range, and municipal/Treasury ratios starting to cheapen. The fundamental situation is just as strong, with states sitting on record-level reserves as they progress through budget season. Once we clear April’s tax deadline and the selling pressure that often accompanies it, the technical backdrop should once again act as a tailwind. Investor appetite for tax-exempt income has been impressive, holding steady all quarter despite expensive valuations, supply surges and periods of low reinvestment demand. As election campaigns kick into gear, retail investors will be reminded constantly of another reason to lock in municipal bond yields, namely, the threat that marginal tax rates will climb even higher. That inclination to favor municipal bonds should add a dose of stability, helping to offset any potential volatility from a data-dependent Fed. While municipals would not be immune to the broader effects of economic or inflationary upside surprises, we would likely view any further selloff as a buying opportunity and continue to leg in at more attractive levels.

Read GW&K’s Quarterly Investment Review for the first quarter here.

With contributions from members of our Municipal Bond Team