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May 2023

Munis Seesaw but Forge Ahead

Key Points

  • Nominal yields continue earning investors healthy tax-exempt income
  • Mixed valuations underscore the importance of active management
  • Credit research is critical amid an aging credit cycle

The first quarter “muni pivot” was not without its headwinds, as investors successfully navigated swings in volatility from inflation, monetary policy, and economic dynamics, leading to solid total returns of 2.78% and 2.73%, respectively, for the Bloomberg Municipal Bond (IG) and Bloomberg Municipal High Yield (HYM) Indexes, notwithstanding months of extreme strength and weakness. 

A resurgence in investor demand for attractive levels of tax-exempt income, with starting yields reaching (and remaining) at their highest levels in several years, and stabilization in some key technical indicators, like municipal bond mutual fund flows, helped drive positive performance by the end of the quarter. Despite a notable decline in nominal yields across the municipal curve of about 30 bps-50 bps during the quarter, longer-term investors should remain engaged as tax-efficient cash flow opportunities may contribute to asset class diversification and capital preservation within portfolios. 


A theme we continue monitoring is the imbalance between supply and demand, where first quarter primary market issuance declined by approximately 25% year-over-year (YoY). With yields higher to begin the year and episodic volatility from events such as the Fed rate hike in February and the banking sector concerns in March, many issuers remained sidelined. However, as municipal bonds look toward the start of a traditionally quiet summer period, there is the potential for more deal flow to materialize over the near term, as yields at the end of the quarter were lower than three months ago. The impact of diminished supply coupled with a benchmark yield curve producing mixed valuations underscore the need for investors to carefully approach security selection, as municipal yields tend to lag and react more slowly to the behavior in the Treasury market. A more expensive (i.e., lower municipal-Treasury yield ratios) municipal market, particularly within short-to-intermediate-term maturities, could limit outperformance in the short run, necessitating the exploration of potential cross-asset class opportunities that generate investor portfolio value. In HYM, typically longer duration and lower quality, those market areas produced excess return YTD and may still offer compelling value for income buyers despite vulnerability to market flows.

Municipal credit quality remains sufficiently intact for IG and HYM bonds. Still, as the economy decelerates and policy decisions weigh on fundamentals, careful due diligence is warranted to mitigate issuer risk and spread implications for specific bonds. Stress indicators for the HYM market remain quite low, while IG rating upgrade/downgrade actions trend favorably YTD, albeit more unevenly across some market sectors, like health care. Given the stage of the credit cycle, we continue to monitor municipal issuers’ fiscal and operational performance, with a bias toward higher quality.


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