Municipal bonds posted solid gains in the second quarter, riding the coattails of a Treasury rally that reversed much of the first quarter selloff in bonds. In many ways, the rebound in the broader market went against the grain of events. After all, during the quarter, unprecedented fiscal stimulus made its way through the economy, with the White House pushing aggressively for even more. A vaccine-led recovery across the U.S. unleashed a mountain of pent-up savings amid easing lockdowns, fueling an acceleration in growth. Inflation readings jumped to levels not seen in two decades, as job openings surged to record highs and supply chain disruptions caused widespread shortages. And yet, Treasury yields declined anyway. Disappointing employment data and a deceleration in retail sales and manufacturing activity called into question the strength of the recovery. Fiscal spending initiatives met stiff resistance in Congress. And the Fed surprised investors by easing off its ultra-accommodative stance on rates and asset purchases, signaling two quarter point hikes in 2023 and setting the stage for a future discussion on tapering. This combination of less-robust growth and a more vigilant Fed led to a significant flattening of the yield curve.
For most of the quarter, municipal bonds kept pace with Treasuries, as federal relief aid boosted credit quality while heightened demand for tax shelters drove record flows into mutual funds. In accordance with the American Rescue Plan, Congress began allocating $350 billion of direct assistance to state and local governments, most of which were already seeing a strong rebound in tax collections. High profile names like New Jersey and New York (city and state), downgraded during the pandemic, saw their outlooks revised higher during the quarter. Connecticut, which hadn’t seen an upgrade in 20 years, earned one from each major rating agency. Even Illinois was upgraded, courtesy of Moody’s in late June, as the rising tide indeed lifted all boats. These fundamental developments emboldened investors to more confidently reach for yield, driving credit spreads back to pre-pandemic levels. But as the quarter came to a close, long-dated municipal bonds lagged the post-FOMC rally of their Treasury counterparts. Heavy supply, rich valuations and emerging doubts on the inevitability of tax hikes all combined to inject the first hint of caution into a previously-indiscriminate buy side. While municipal bonds are still far ahead for the year, the cheapening of relative value ratios off record-low readings was a welcome development.
Heading into the deep summer months, the near-term technical backdrop for municipals should continue to be supportive. Over the next two months, seasonally-high coupon and maturity redemptions are estimated to outstrip gross supply by $25-30 billion. Secondary market activity, which ground to a two-decade low in the first half of the year, will likely remain depressed as scarce supply and embedded capital gains limit the incentive to sell. But even though June provided some relief from record-high valuations, ratios still begin the quarter richer than any level seen prior to 2021. With such little cushion, municipal bonds should more closely track the course of the Treasury market. That could translate into increased volatility, bearing in mind all the larger questions surrounding the transitory nature of inflation and the paths of fiscal and monetary policy. Municipal investors will also stay focused on the infrastructure debate in Washington, the ramifications of which could mean altered tax policy, more investment opportunities and the reinstatement of municipal financing tools ranging from tax-exempt advanced refundings to a revamped Build America Bonds program. Positioning in this environment is tricky given the potential impacts from a crosscurrent of variables. At this stage, managing risks feels more important than seizing opportunities. But often the former leads to the latter when the alert investor properly prepares.
Our second quarter trading activity was directionally similar to the positioning shift we executed in the first quarter. Recall, earlier in the year, we took advantage of a spike in rates to extend duration, aggressively selling bonds in the five-year area of the curve to reinvest in 10-to-15 year maturities. The idea was to capitalize on a window of heavy new issuance where deals were mostly priced to sell. We continued in that vein through much of April, throttling back only after rates had dropped and the curve had flattened. Credit spreads compressed further and seesawing ratios finished June well through fair value levels. While the technicals in the market suggest a strong third quarter for municipal bonds, we continue to hold a significant position of shorter-term bonds should the emergence of an unforeseen correction create an opportunity to exploit.