Munis Fall Short Of Seasonal Expectations In August

August update

  • Municipals posted negative total returns amid rising interest rates.
  • Issuance exceeded tempered expectations, while demand waned as performance struggled.
  • Late-cycle macro dynamics and fading seasonal tailwinds could create opportunity in the autumn.

Market overview

Municipal bonds deviated from the seasonal trend and posted negative total returns in August. Interest rates rose on the back of resilient economic growth, elevated Treasury supply, and a hawkish tone from the Federal Reserve (Fed) at the Jackson Hole Economic Symposium. The yield on the benchmark 10-year Treasury note closed at a new cycle high of 4.34% late in the month. Rich valuations and less favorable supply-and-demand dynamics prompted municipals to underperform comparable Treasuries. The S&P Municipal Bond Index returned -1.10%, bringing the year-to-date total return to 1.65%. Shorter-duration (i.e., less sensitive to interest rate changes) and higher-rated bonds performed best.

Issuance exceeded expectations at $37 billion, a 40% month-over-month increase, bringing the year-to-date total to $234 billion, down 10% year over year. As a result, the typical tailwind provided by net negative supply was subdued, as reinvestment income from maturities, calls, and coupons outpaced issuance by just $9 billion, compared to $14 billion last year. At the same time, demand waned alongside performance, and the asset class posted its first monthly net outflow since May.

While we acknowledge that near-term volatility will likely remain elevated, we believe that the next couple of months may prove to be a favorable period to add duration. Interest rates have historically peaked about two months prior to the end of a Fed tightening cycle, making the recent increase in yields a potential opportunity. In addition, supply-anddemand technicals in the municipal market tend to turn less constructive in September and October before strength reemerges into year-end, making the autumn a great time to buy ample supply at bargain prices.

Strategy insights

We maintain a neutral-duration posture overall. We prefer an up-in-quality bias and remain increasingly selective in non-investment grade. We strongly advocate a barbell yield curve strategy, pairing front-end exposure with an increased allocation to the 15-20-year part of the curve.