Municipals Seesaw into the Summer
• Fed decisions should drive market performance and sentiment
• Credit fundamentals support broad near-term stability
• Market yields provide an attractive entry point for long-term investors
Municipals encountered choppy markets during the second quarter, as investors weighed inflation implications and Fed tightening against “hard to ignore” yields on investment grade (IG) and high yield municipal (HYM) bonds, leading to mixed performance. The challenging market environment is unlikely to abate soon.
Policy actions and fluctuating market demand should influence the performance trajectory of IG and HYM bonds during the second half. We expect municipal investors to engage the market during periods of weakness, unlocking attractive long-term portfolio value. For liquidity mandates, absolute yields on the front end of the curve continue offering a meaningful advantage over traditional money market instruments. In the near term, municipal market returns should ebb and flow alongside Treasuries, with periodic directional overshoots in response to technical factors.
With summer underway, municipal participants will pay close attention to seasonal market forces that typically lead to price support, given the [usually] lower bond supply and reinvestment needs. However, combined fund outflows of around $75B YTD will likely test investors’ confidence should trends persist. We expect municipal market liquidity to normalize when Treasury rates show a more stable trading range, slowing investor redemptions and a return to net additions. Still, HYM bonds present good value to investors as the forced selling of longer-maturity bonds in response to inflation/rising rates has caused their nominal yields to increase more quickly than comparable Treasuries (chart 1). In our view, nominal yields in the municipal market provide potential performance tailwinds on a forward-looking basis.
Our constructive outlook for municipal credit reflects revenue outperformance and budget surpluses since 2021 for most issuers. Many state and local governments have bolstered reserves and prudently allocated robust federal aid, lessening their operational risk heading into the next budget cycle (chart 2). We continue monitoring select sectors while assessing the impact of financial market volatility on the health of public pension plans. Moderation in the economy will affect tax collections as spending and labor growth slow. We see opportunities to trade up credit quality at little cost as spreads remain somewhat compressed, especially for low-IG bonds.
Please Note: Past performance or performance based upon assumptions is no guarantee of future results.
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