The municipal market has shown mixed performance having returned -3.95% in tax exempt and -3.69% in taxable over the third quarter of 2023, which compares unfavorably to US Aggregate returning -3.23%, and US Treasuries returning -3.06% during the same period.1,2,3 In high yield, corporate high yield outperformed the municipal high yield market returning 0.46% for the quarter compared to a -4.24% return for the Municipal High Yield Index.4,5
A tale of two halves
The first half of Q3 saw strong outperformance driven by a lack of supply in the primary market, pushing up secondary market values. However, during the latter part of Q3, investors witnessed a reversal in this trend as relative supply increased, while reinvestment capital in the market remained limited. Additionally, treasury rates pushed up and fund flows stayed negative, which only exacerbated negative performance. This resulted in underperformance compared to corporate bonds.
The Q3 ended with Muni-Treasury ratios at 73%, 75%, and 93.9% in the 5-, 10-, and 30-year parts of the curve, respectively.6 We think the sell off to end the quarter has created an attractive entry point for investors to invest in the municipal market as ratios now look closer to historical fair value. However, we remain cautious to begin Q4 as technicals may slow outperformance in the near term. This underperformance carryover from the third quarter should abate as we get further into the fourth quarter.
Sectors remain influenced by consumer resilience
The fundamentals of the municipal bond market remain influenced by the resilience of the consumer and labor market, which has resulted in strong tax collections, although they have declined from their recent peaks. We believe several sectors to offer attractive entry points.
Cost pressures in the healthcare space have eased somewhat, in addition the underperformance for the sector has created an opportunity for investors looking for an entry point into a sector that remains critical to the infrastructure of the American health care system.
Highways and housing bonds
The Infrastructure Investment and the Jobs Act and the Inflation Reduction Act have provided these sectors with a strong fundamental backdrops as renewed capital investments into the space have provided issuers with an expanded menu of financing options to help improve the quality of these sectors and strengthen issuer balance sheets.
Both charter schools and higher education present potential opportunities. Charter schools, in particular, have gained wider acceptance as an alternative to public school education, leading to more funding support on federal and state levels. Higher education generally performs well in counter-cyclical environments.
On the flipside we are cautious on sales tax-backed bonds as any slowdown in consumer spending may lead to deteriorating collections over time, as well as issuance that supports new construction as labor cost and materials remain elevated.
What’s to come for municipal bonds?
The municipal bond market continues to be influenced by movements in the Treasury market. The higher-for-longer theme set by the US Federal Reserve (Fed) has affected the longer-duration corner of the market. Recent market activity has shifted from expectations of 3–4 rate cuts, as priced at the beginning of Q3, to expectations of 2–3 cuts in 2024, per the Fed’s last meeting in September. Leading some market participants to reconsider where the neutral rate of interest is in the post-pandemic market.
The municipal bond market’s yield curve is inverted in the belly, but positively sloped and steepens a bit in the longer end of the curve providing attractive yield for those who target these maturities – a strategy that can potentially generate alpha and enhance an investor's total return. The municipal yield curve, illustrated in the chart below, is inverted in the 3- to 12-year part of the curve. This inversion is why investors should be wary to invest in that piece of the curve. As the curve normalizes and steepens, that part of the curve is vulnerable to underperformance.
Chart 1. The municipal curve is inverted in the 3–12 year part of the curve
Source: Bloomberg U.S. Municipal Index, as of September 2023.
This recalculating of neutral and shift in rate expectations has put pressure on the intermediate portion, or belly, of the yield curve. As it stands today, ratios in the 3-, 5-, 10, and 30-year part of the curve stands at 72.98%, 73.22%, 75.15%, and 93.90%, respectively.6
We believe these ratios offer an attractive entry point into the municipal market, which are now in and around fair value with the potential to become richer as the quarter rolls along. We would continue to encourage a barbell approach, allocating investments to the short and long parts of the curve while avoiding the vulnerable intermediate segment.
A look ahead at Q4
In summation, we think municipals present attractive relative value when compared to its corporate and taxable counterparts to begin the fourth quarter. As we look ahead through the quarter, we believe technicals in the market point to a more favorable backdrop as a dip in supply as well as a tick up in maturity and coupon payments may provide the market with an additional tailwind over the quarter.
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.