- Municipal bond investors may want to lock in longer duration, as leading indicators point to a slowing economy, potentially tightening credit conditions and decelerating inflation.
- A historic inverted municipal bond yield curve should dictate portfolio positioning. For core investors, a barbell strategy can capture the cheapest parts of the curve; investors limiting duration can find ample yield on the short end.
- Limited supply and strong demand typically support municipals in the summertime, which may positively impact valuations. We like bonds in high demand or, conversely, use the technical backdrop to upgrade portfolios and cross over into Treasuries if the municipal/Treasury ratios collapse.
- Despite a slowing economy, fundamentals are still strong compared with other periods, such as just before the global financial crisis and the COVID-19 pandemic. Tax revenues may have come off their peak, but municipalities’ high cash balances and reserves, and budget flexibility, should allow most issuers to adapt.
A historic inverted municipal bond yield curve creates opportunities
For the first time in 10 years, investors can lock in 5%–6% taxable-equivalent yields in the intermediate and long parts of the municipal bond curve. Here are the conditions creating this opportunity, and how investors can potentially benefit.
Inflation (measured by the consumer price index) has declined significantly, from 9% in June 2022 to 4% today, and although it’s not falling as quickly as the Federal Reserve (Fed) would like, we believe its path continues to point downward.
Still, the economy is softening as the effects of 500 basis points (bps) of Fed rate hikes impact borrowing, lending and balance sheets. The collapse of three regional U.S. banks has also started to tighten credit conditions, and banks will need to shore up their balance sheets and raise credit standards. Headwinds for commercial real estate, specifically office values, which are under pressure as many employees are reluctant to return to the workplace, could also contribute to a more challenging economic environment.
All these metrics imply lower rates lie ahead. That’s why investors should look to lock in current rates, in the intermediate and long parts of the municipal curve.
Embrace the curve
The muni curve is almost always steeper than the Treasury curve due to uncertainty about future tax rates, as well as strong demand from individuals for bonds maturing within 10 years, and because longer-dated issuance is normally tied to the expected life of an individual project.
While this remains the case, for the first time in decades the municipal bond yield curve is inverted. This is the result of tremendous demand from individuals for separately managed accounts in the one- to 10-year part of the curve, combined with record mutual fund outflows in 2022 that particularly pressured the intermediate and long parts of the curve, cheapening those areas.
Right now, the muni curve is spoon-like, with the front end elevated due to the Fed’s rate hikes and falling but still sticky inflation. The curve dips—the 10-year yield is 48bps lower than the one-year yield—then steepens again after 10 years, with a spread of 69bps between 10 and 20 years (Exhibit 1).
Core fixed income portfolios can use a barbell strategy to capture the cheapest parts of the curve: the very front end and between 10 and 20 years. That longer part of the curve is where we recommend investors lock in higher yields and mitigate reinvestment risk that is likely to worsen as the possibility of recession grows.
An inverted municipal bond market yield curve gives investors a chance to lock in higher long yields
Exhibit 1: Treasury, AAA muni and AAA muni taxable-equivalent yield curves
Summertime technicals: A fair-weather friend
With the start of summer, municipal bond demand has historically outpaced supply, effectively shoring up the market. Supply becomes limited, as fewer bonds are issued in summer, while demand tends to be strong because a significant number of bonds mature or pay interest in June, July and August, and their holders need to reinvest cash in their accounts.
These supply-and-demand technical dynamics may be even more pronounced this year. For one thing, supply is already down 27% this year vs. the same period in 2022. Demand will probably be further augmented as municipal bond investors seek to lock in high yields. Individuals in high tax states, such as New York, California and Oregon—among the largest buyers in the market—will be starved for supply over the next few months, allowing us to sell into that demand.
Taken together, these circumstances should impact valuations and be a source of interesting relative value trades. One possible outcome: As municipal bond valuations rise and yields decline, Treasury bonds may become relatively more attractive. If Treasuries yield more than municipals on an after-tax basis, we will buy Treasuries. The likely strong demand should also allow us to continue to look for opportunities to upgrade our portfolios with fundamentally strong credits at any rating level.
Municipal credit fundamentals: No change in the forecast
State finances are in much better shape than prior to the global financial crisis of 2008 and the COVID-19 period, thanks to substantial federal aid, strong reserves and revenues that, while off peak levels, are still very strong historically.
State and local governments have budgeted conservatively and honed their ability to weather economic storms, using the many tools at their disposal. For example, California’s governor—by shifting capital spending, delaying funding and reducing one-time expenses—plugged a $31.5 billion gap in the state’s budget without drawing down significant reserves. While California isn’t of the woods yet, this demonstrates issuers’ willingness and ability to balance the budget without issuing debt or depleting reserves, maintaining financial flexibility to address future budgetary pressures.
As the Fed winds down its rate hiking cycle, some of the cost pressures on municipal bond issuers—higher interest rates, higher input costs and higher labor costs—could moderate, bolstering their credit profiles.
We have also been scrutinizing credits and sectors, such as health care and private education, that may be under increasing pressure if the economy weakens significantly. Together with our assessment of valuations, we are making the appropriate changes in our portfolios.