Perspectives

Municipal bonds posted their strongest third-quarter returns since 2011, erasing earlier losses and pushing year-to-date performance into positive territory. Following the Treasury market’s lead, tax- exempt yields fell significantly, particularly at the short end, as the Fed kicked off its first easing cycle in four years. A surge in new issue volume, however, tempered the municipal bond rally, as borrowers rushed to take advantage of lower rates and stay ahead of any election-related volatility. Supply jumped 38% year-over-year, with $136 billion coming to market during the quarter, keeping annual issuance on track to surpass $500 billion for the first time ever. The influx of supply forced many issuers to offer concessions to attract buyers, especially given the large number of megadeals hitting the street on a weekly basis. Demand actually hung in well under the circumstances, supported by heavy reinvestment flows in July and August and a resurgence of mutual fund inflows through-out the quarter. By the end of September, municipal bond yields had fallen 20-80 basis points from June levels, with ratios relative to Treasuries holding steady at the short end, but cheapening slightly for longer maturities. The municipal curve steepened in line with the broader market, marking the end of a prolonged inversion and returning to a more normalized slope.

Macroeconomic Drivers Behind Market Gains

Broader macro forces drove the third-quarter gains, as economic data pointed toward significant progress on the Fed’s dual mandate of maximum employment and stable prices. Inflation pressures eased, with key indicators moving closer to the Fed’s two percent target (“a few tenths above two” in Fed Chair Powell’s words). At the same time, the labor market cooled off, with decelerating job creation, rising unemployment and increased workforce participation. Citing moderating growth and well-anchored long-term inflation expectations, the Fed delivered a 50 basis-point rate cut in September and indicated that two more 25 basis-point cuts could follow by yearend. The move was widely anticipated, though the magnitude was in doubt right up until decision day. By the end of September, the yield on the two-year Treasury had fallen 111 basis points for the quarter, far more than the 62 basis-point drop for the 10-year, pushing the 2s-to-10s slope back into positive territory for the first time in two years. The Fed has rejected any hint of “mission accomplished” on their mandate and stressed that where we go from here will depend on the data.

Municipal Bonds on Solid Footing for Q4

The municipal bond market enters the fourth quarter in excellent shape. Tax-exempt yields, while down from their year-to-date highs in May, are still elevated by historical standards. The yield curve has normalized, with the middle portion now back to an upward slope, improving the prospects for roll and increasing expected return in the coming months. On the fundamental side, state and local governments continue to enjoy a stable financial outlook, with most looking at low-single-digit revenue gains, manageable expense growth, and significant financial flexibility, a product of robust reserve balances. To be sure, we could see some near-term volatility emerge, with heavy new issue volume, seasonally low reinvestment flows, and investor caution heading into the November election.

Market Positioning & Outlook

Even so, the tailwind of the Fed’s easing cycle, still in its early innings, should help to counter any hesitation to step into the market, as the desire to lock in favorable tax-equivalent yields before they decline may be hard to resist. In that way, we would likely view any market selloff this fall as a buying opportunity.

Our trading activity in the third quarter reflected the elements at play in the market, namely, heavy primary issuance and very light secondary flow. Approximately three-quarters of our purchases came from new deals, which offered meaningful concessions in order to facilitate market absorption. With so many issuers competing for investor attention, we were able to sift through the bevy of offerings, exploiting the most value-added opportunities. With supply showing no signs of relenting to start the fourth quarter, we remain well-positioned to take advantage of any potential volatility from the upcoming election cycle.

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

With contributions from members of our Municipal Bond Team