Executive summary
- The recent municipal bond selloff has created one of the most compelling entry points in years.
- With yields above long-term averages and at levels rarely seen in the last two decades, the municipal market offers a unique opportunity set, namely historically attractive tax-equivalent income, favorable relative value versus fixed income alternatives, and the potential for enhanced returns.
- While near-term volatility may persist, strong credit fundamentals and elevated starting yields make a powerful case for putting cash to work now.
How we got here: The September selloff
The month of September marked a major regime shift for rates. The Federal Reserve delivered its first rate hike in three years. Subsequent commentary pointing to the prospect of additional hikes sparked a selloff, which quickly broadened as strong economic data prints led markets to reprice growth expectations. Elevated energy prices, fiscal concerns, and heavy issuance all provided support to the move higher in yields. The 10-year Treasury ended the month at 5.30%, a level last reached in 2007.
Even more remarkable is the repricing in the municipal market. Here, the effect of an unfavorable rates backdrop was amplified by elevated issuance and seasonally weak reinvestment demand. Year-to-date (YTD), fund flows have provided meaningful support to the new issue market which is on track to set a new record ($600 billion of issuance projected by year end). However, as volatility increased, inflows slowed and losses grew. Enter tax loss harvesting. Investors seeking to crystallize capital losses flooded an already weak secondary market. Municipal yields rose up to 100 basis points (bps) and the 10 year ended the month at 6.93% yield on a tax equivalent basis.
Where we are now: Yields in context
Today's municipal market looks fundamentally different than it did just a few months ago. Municipal yields are near their highest levels since the Great Financial Crisis (GFC), which began in 2007, and now exceed their 20-year averages across the curve. For clients in the top income-tax bracket, municipals now compare favorably to other fixed income sub-asset classes on both risk-adjusted and tax equivalent bases, a welcome change as municipals spent much of this year at relatively rich valuations.
Despite some flattening YTD, the municipal yield curve remains steep relative to Treasuries due to issuance patterns. Consider the spread between 2-year and 30-year maturities of 80bps for Treasuries and 169bps for municipals. This dynamic creates greater opportunities for carry and roll-down return (the price appreciation associated with rolling into a lower yielding maturity over time) in the municipal market should the curve maintain its shape.
History also provides encouraging context. According to a J.P. Morgan Investment Bank study covering a 30-year period, the 12-month forward return was substantially higher when the 30-year municipal yield exceeded 4.5% (an average of 7.0% as compared to 4.2% otherwise). As of October 2nd, the 30-year sits comfortably above that level. While acknowledging that past performance is not indicative of future returns and that downside risk remains, these findings imply that the current yield environment offers attractive entry points for long term investors.
Calling the peak
Municipal yields have reached levels that are hard to ignore, and the rally of the first few days of October suggests investors are taking note. However, that does not mean that yields are bound to fall from here. In fact, there are many factors in place that could contribute to near term volatility. For one, projected issuance is elevated with nearly $130 projected between now and year end. Redemptions are typically low in both October and November; in the absence of reinvestment money, the market will be reliant on fund flows to absorb this new issue. Lastly, growing tax loss selling could weigh on the secondary market.
However, the case for municipals lies not in calling the peak, but rather in locking in historically elevated yields. At today’s levels, the income opportunity is sufficiently attractive that it compensates for near term volatility and creates a strong foundation for future total returns, even without the price appreciation that would come from falling rates. In other words, investors do not need to perfectly time the market to benefit from today's unique opportunity.
Credit fundamentals remain sound
Municipal credit quality peaked in the immediate aftermath of the pandemic due to an influx of federal aid that capped years of post-GFC reserve growth. While reserves have moderated from those record levels, they remain well above their long term averages. We also highlight the fiscal restraint that has become a hallmark of state governance and tax collections that continue to exhibit sound growth. Recently released data indicate that state tax receipts increased 6.3% in the 12 months ending on June 30th, with growth broad based across states and revenue type.
These fundamentals provide an encouraging backdrop for investors seeking income and stability. At the same time, we see value in an up-in-quality approach to credit selection given historically tight credit spreads. High grades have borne much of the selloff, creating opportunities to capture elevated yields without sacrificing credit quality.
Best thinking
At today’s levels, the municipal market offers unprecedented investment opportunities. Those already invested in the market may consider harvesting losses to offset gains elsewhere in their portfolios while repositioning into higher prevailing yields. Those concerned with timing risk, could consider a gradual deployment of capital to capture today’s attractive starting yields while retaining dry powder should rates move higher.
From a positioning perspective, we see value in extending duration to capture incremental yield and potential roll down return. In light of historically tight credit spreads, we favor an up-in-quality approach to credit selection.
Most importantly, we believe investors should focus on the opportunity in front of them as historically attractive tax-equivalent yields, record supply, strong credit fundamentals, and improved relative value have combined to create a compelling case for municipals.