Opportunity Knocks for Municipal Investors

September update

  • Municipal bonds sold off considerably in September alongside vastly rising interest rates.
  • Limited demand and a seasonal transition back to net positive supply weighed on the market.
  • The reset in yields and valuations provides an attractive long-term buying opportunity.

Market overview

Municipal bonds posted sharply negative total returns in September amid heightened volatility. Interest rates rose rapidly and pressured fixed income assets as the market navigated a moderate rise in inflation, continued strength in the labor market, surging oil prices, and more hawkishthan-expected message from the Federal Reserve (Fed). The asset class, dragged down by rich valuations and less favorable supply-and-demand dynamics, lagged versus comparable Treasuries. The S&P Municipal Bond Index returned -2.68%, bringing the year-to-date total return to - 1.07%. Shorter-duration (i.e., less sensitive to interest rate changes), AA-rated bonds and the corporate-backed, utility, and transportation sectors performed best.

Issuance was light at just $28 billion, 23% below the fiveyear average, bringing the year-to-date total to $263 billion, down 8% year-over-year. However, issuance still outpaced reinvestment income from maturities, calls, and coupons by nearly $6 billion, weighing heavily on the market as seasonal net negative supply during the summer months yielded to net positive supply. As a result, deals were oversubscribed just 3.2 times on average, the lowest total since February. At the same time, investors displayed caution as interest rates rose, and mutual fund flows were increasingly negative, exacerbated by a pickup in tax loss selling late in the month.

While the recent sell-off was significantly larger and more volatile than expected, seasonal performance weakness in the autumn was broadly anticipated. With the Fed nearing the end of its tightening cycle, we view the reset in yields and valuations as an attractive long-term buying opportunity. We foresee using any material pickup in issuance to add some duration and lock in durable yields.

Strategy insights

We maintain a neutral-duration posture overall, albeit slightly longer than last month. We prefer an up-in-quality bias and remain both cautious and selective in noninvestment grade. We advocate a barbell yield curve strategy, pairing front-end exposure with an increased but modest allocation to the 15-20-year part of the curve.