Perspectives

Municipal bonds posted solid gains in the first quarter, piggybacking a strong, but extremely volatile, rally in Treasuries. Although interest rates ultimately finished lower for the quarter, each month produced wildly different results. In January, yields declined sharply as weak economic  data fueled speculation of a Fed pivot. That notion gained more currency after the FOMC executed a slimmed-down quarter-point hike at its meeting on February 1. Two days later, however, a blowout jobs report undermined any thoughts of a slowdown, setting the stage for a violent reversal in rates. Worries over a recession faded, giving way to talk of a potential “no landing” scenario, where the economy continues to grow despite the Fed’s efforts to tame inflation. By early March, the yield curve had reached its deepest inversion in 40 years. The no-landing theory was ultimately done in, however, by the collapse of Silicon Valley Bank and subsequent turmoil in the banking industry. Rates plummeted into quarter end in a classic flight to safety, as investors worried that a pullback in lending posed a serious threat to future economic growth. As March ended, markets were anticipating multiple Fed cuts by year-end, even as central bank officials continued to forecast at least one more hike and no cuts until 2024.

Municipal bonds kept pace with the rally in Treasuries even though relative value ratios started the year at historically expensive levels. Two factors contributed to that outcome: 1) a significant drop in first quarter supply, and 2) little credit exposure to the banking mess. As to supply, new issue volume was down 27% on a year-over-year basis, extending a run of sparse issuance that had been in place since last summer. It helped that demand had finally stabilized, as mutual fund redemptions slowed to a trickle, a far cry from last year’s relentless and record-setting outflow cycle. On the credit side, when the banking crisis erupted, municipal bonds reaped the benefit of their haven status, drawing investment flows from other areas of the market more vulnerable to a run on the nation’s lenders. Since the 2008 financial crisis, improvements in cash management
and debt structuring practices have greatly reduced the risk to municipal bond borrowers in the event of bank failures. Despite financial market distress and severe rate volatility, the latter leading to the first meaningful inversion of the tax-exempt curve, municipal bonds proved resilient in the first quarter, posting impressive gains and acting as a reliable source of stability.

We believe municipal bonds begin the second quarter in excellent shape. The technical picture should improve with a pickup in rollover demand amid still-sparse issuance. Meanwhile, municipal bond credit quality has rarely been better. Two years of unprecedented revenue growth has led to record reserves across the space. Even Illinois, once the epitome of political brinksmanship and pension mismanagement, has stabilized. During the quarter, the state was upgraded to the A-rating category after teetering on the brink of junk during the depths of the pandemic. The challenge for the market is that all this good news has been priced in. Relative value ratios stand near historical tights, leaving less cushion against the forces driving Treasuries. One consequence of that has been the frontend curve inversion, a novelty that has tempted some long-term investors to shorten up and grab the yield. That is likely a mistake. Reinvestment risk looms large, especially considering where we are in the current monetary cycle. Excess return from roll is not only still available in longer maturities but would increase exponentially in the event of a pivot to easing. And should the Fed stay higher for longer, investors will be well compensated by the attractive yields available at steeper segments of the curve.