Municipal bonds fared better than most fixed income alternatives in the first quarter, but ultimately could not escape the gravitational pull of a bond market selloff that saw Treasury yields surge to their highest levels of the pandemic era. The major catalyst came in January, when the Democrats unexpectedly secured control of the U.S. Senate, clearing the way to add a $1.9 trillion fiscal stimulus package to an economy already buoyed by the momentum of a successful vaccine rollout. Investors responded quickly, repositioning for a sharp acceleration in growth and a revival of long-dormant inflationary pressures. The yield on 10-year U.S. Treasury shot up 82 basis points over the quarter and the curve steepened significantly, as the futures market pulled forward by a year the date of a first rate hike. But the Fed pledged patience and dismissed pricing pressures as temporary. While inflation expectations had pushed to decade-highs, policymakers emphasized that over half of the increase in nominal yields was driven by a surge in real rates, a welcome reflection of investor confidence in the recovery.
For much of the quarter, the municipal bond market ignored the weakness in Treasuries, focusing instead on the windfall coming out of Washington. Few asset classes benefited more from the American Recovery Plan, which sent hundreds of billions in direct aid to states, local governments, school districts, universities, airports, toll roads, mass transit, you name it. These same entities were bolstered further by the knock-on effects from individual stimulus checks and roaring capital markets. Meanwhile, proposals to increase taxes had investors scrambling to gobble up municipal bonds to avoid Uncle Sam’s reach. Money poured into the space in breathtaking fashion. Mutual funds saw more inflows to start the year than any on record. Credit spreads contracted to pre-pandemic levels. By mid-February, tax-exempt rates were still unchanged for the year despite a sharp selloff in Treasuries, leading to unsustainably-low relative value levels. As a result, when Treasuries continued to weaken, municipal bonds were forced to follow suit. Even so, for the quarter, tax-exempt rates rose less than half of what we saw from Treasury yields.
Our trading activity in the first quarter reflected the changing dynamics of the market. Higher rates, steeper curves and irrational valuations created an opportunity to shift our positioning. When the five-year muni/Treasury ratio dropped to the low-40’s (it would bottom at 38% on February 16, 2021), we decided to give the market what it demanded, targeting for sale bonds that matured in 2025 and early 2026. As the quarter progressed, issuance accelerated as relative value cheapened, providing a favorable window to reinvest. We put the proceeds back to work in 10-15 year maturities, capitalizing on a new issue market where bonds were priced to sell. By moving out on the curve, we were able to pick up over 100 basis points of yield, improve expected return from bond roll and lock in wider credit spreads. While we have extended duration modestly, we still have plenty of dry powder in the short-end of the curve that can be deployed in similar fashion should conditions warrant.
The fundamental outlook for municipal bonds continues to brighten. Trillions in federal stimulus aid, with the possibility of more to come later this year, has helped offset the revenue hit from the pandemic, even for the hardest hit credits. As the economy rebounds with the help of a successful vaccination campaign, finances should only mend further. As it is, rating agencies have already moved most sectors to stable from negative and the chaotic selloff of last spring seems a distant memory. While still low in absolute terms, yields have risen significantly off the rock-bottom levels of the summer (the 10-year has nearly doubled). The yield curve has steepened meaningfully and, as of quarter-end, stood more in line with its historical averages. This has increased the attractiveness of longer maturity debt, as the expected return from bond roll becomes far more prominent. Relative value ratios remain fairly expensive, but the odds for a substantial cheapening seem minimal. More likely, ratios will stay in a narrow channel, held in by a combination of improving credit metrics, tight supply and the prospects for higher marginal tax rates.