Perspectives

Municipal bond yields rose across the board in the second quarter, driven by elevated tax-exempt supply and Treasury market volatility. It all began in April, with broader rates spiking in response to accelerating job growth and a number of higher-than-expected inflation prints. Municipal bonds actually hung in well despite the month-long Treasury rout and demand for the asset class appeared unlimited. But as April turned to May, the picture changed dramatically. At the macro level, growth and inflation started to ease just as the Fed had emphasized its data-dependent framework, leading to a rebound in Treasury prices. By then, however, municipal bonds were dealing with an onslaught of supply in the face of extremely rich relative value ratios, a combination which proved too much to digest without significant seller concessions. Trading remained orderly and new deals cleared the market without any major hiccups, but it took a significant May correction to do so. In June, a measure of normalcy returned to the market. Issuance remained elevated, but summer technicals kicked in. Heavy June 1 rollover demand, the beginning of a seasonal pattern that should extend through August, led to a relief rally that pared earlier losses. The 10-year municipal/Treasury ratio, which began April under 60%, pushed out as far as 71% before settling back to 65% to end the quarter.

Activity

The backup in municipal bond yields produced mixed performance for the quarter and led to other interesting outcomes. Intermediate maturities took the brunt of the losses, as investors shied away from that segment of the curve with the lowest absolute yields. The short and long ends, by contrast, posted positive returns, as each area benefited from higher carry and smaller rate adjustments. Both five- and 10-year yields jumped north of 30 basis points (bps) for the April-June period, while the two-year rose 14 bps and the 30 year edged up only 4 bps. As a consequence, the inversion of the curve became much less pronounced, with the 2/10’s segment moving to -27 bps from -46 bps. At the same time, the long end lost some of its own advantage against the belly of the curve, with 10/30’s slope falling to 88 bps from 117 bps. Investor preference for the maximum yields also led to tighter credit spreads. Enticed by a stable economy, strong fundamentals, and historically low default rates, investors reached down in quality, leading to the outperformance of BBB and single-A names within the investment grade universe. High yield did even better, as limited supply and unusually large inflows into that sentiment-driven space had mutual fund managers bidding up a shrinking pool of available product.

Outlook

The outlook for municipal bonds improved significantly over the course of the quarter. Absolute yields finished June at the top end of their long-range averages. Relative value ratios have finally eased off ultra-tight levels, providing more cushion against Treasury volatility going forward. Municipal bond credit fundamentals should prove resilient even if we see some economic slowing, with conservative budgeting practices supported by record-high reserves. In the near-term, we could even see strength from the typical summer blend of elevated reinvestment flows and tapering issuance. And yet, there is also room for caution. The long end of the curve has flattened substantially, squeezing out some of the extra yield and roll that had been available over the last few quarters. And while municipal bond fundamentals are unambiguously positive, spreads have compressed substantially, reducing the potential for gains from further tightening. And finally, with the election only a few months away, we could see an increase in volatility and headline-driven pullbacks. We will respond to unfolding circumstances with our active-management approach, looking to mitigate the risks that emerge and take advantage of the opportunities that present themselves.

Read GW&K’s Quarterly Investment Review for the second quarter here.

With contributions from members of our Municipal Bond Team