The municipal market was a full participant in the global bond rout that unfolded over the third quarter. Broad fixed income losses piled up each month, but accelerated after the September FOMC meeting, where Fed policymakers signaled a determination to hold interest rates higher for longer. Investors were taken off guard by the hawkish messaging, given the trajectory toward lower inflation and reduced froth in the labor markets, particularly over the last three months. But as Jay Powell pointed out in his post-meeting press conference, the recent jump in Treasury yields was less about inflation and more about real yields rising in response to stronger-than-expected economic data. The Fed Chair listed a number of plausible explanations for the economy’s surprising resilience (lagged effects of tightening, higher neutral rate, more durable consumer and business balance sheets), but emphasized the need to guard against overheated growth, lest it threaten the headway made to date in restoring price stability and full employment. The markets shared his caution, as the yield on the 10-year Treasury note climbed 73 basis points over the quarter, closing September at 4.57%, its highest level since 2007.
Municipal bonds underperformed Treasuries, ultimately succumbing to the combined weight of negative sentiment and rich valuations. Early in the quarter, municipal bonds appeared set to enjoy one of their typically strong summers, driven by the technical tailwinds of low issuance and heavy rollover demand. In fact, in July, mutual fund flows turned positive for just the second time in the prior 18 months. But that momentum wouldn’t last. By mid-August, stretched valuations had made the market vulnerable to any signs of weakness. When Treasury yields continued to march higher, there was little cushion to absorb the hit to prices. By the time the September FOMC sparked another leg down in the broader market, municipal bond investors had endured enough. The bid side of the street evaporated amid an uptick in supply and the tax-exempt curve gapped higher. Ten-year AAA yields jumped 89 basis points over the quarter, reaching levels not seen since 2009. The rise in rates resurrected long-dormant risks that will need to be managed. Those who haven’t had to understand extension risk or de minimis-adjusted yield calculations will be at a disadvantage. With risks, however, come opportunities, and this summer’s correction promises to be no different.
The third quarter was a tale of two completely different trading environments. July saw a continuation of the first half of the year where light issuance and heavy demand made sourcing bonds extremely difficult. Sellers were reluctant to part with paper, knowing it would be nearly impossible to find suitable replacements. But as the quarter progressed, the combination of rising rates and a pickup in issuance began to negatively influence sentiment. By September, with yields gapping higher in double-digit increments on a daily basis, the market was in full selloff mode and opportunities to find value became readily available. New issues had to price cheaply to account for the increased volatility and the secondary market followed suit. Purchase yields often topped 4%, something we haven’t seen in a while. As we enter the fourth quarter, we will continue to look for ways to exploit the ever-changing yields in a trading environment that just got a whole lot more interesting.
The outlook for the municipal bond market has improved considerably. The steep inversion in the front half of the curve has become much less severe and relative value ratios begin the new quarter at their cheapest levels of the year. Nominal yields have pushed to decade-plus highs, creating attractive entry points all along the curve. Fundamental credit quality remains solid, with states budgeting for only modest revenue reductions after two years of record collections. States have a proven track record of managing through economic slowdowns and this time around will have the added benefit of sitting on the largest pile of cash reserves ever. October’s history of market volatility may create additional opportunities, especially as investors attempt to handicap the reaction function of a data-dependent Fed. While most view a higher rate environment as something to avoid or protect against, the bigger danger, even under current circumstances, is reinvestment risk. Elevated yields should be embraced and locked in, because you never know when they will be gone.