Munis break their streak

October 07, 2019

Highlights

• The muni market’s 10-month winning streak finally broke in September.
• We expect interest rate volatility to continue for the near term.
• Muni valuations have become more attractive relative to Treasuries.

Market overview

After 10 consecutive months of positive performance, the muni market’s winning streak came to an end in September amid persistent interest rate volatility. The S&P Municipal Bond Index declined -0.65% over the month, putting the year-to-date return at 6.57%. Although the Fed cut its target range in mid-September, interest rates ended the month higher given a backdrop of moderate economic growth, slightly higher inflation and some easing in trade tensions. (Bond prices fall when rates rise.)

Compared to Treasury bonds, municipals modestly underperformed across the curve; however, this helped reset relative valuations to more attractive levels, particularly in the front and intermediate part of the curve.

The market tailwinds supporting the recent rally in muni performance lost steam in September. New issuance accelerated given a combination of low rates and a surge of deals designed to work around the elimination of the tax exemption for advance refunded debt. At the same time, rate volatility caused demand to wane, but net flows into municipal bond funds remained positive.

Outlook 

We expect rate volatility will continue as geopolitical uncertainties remain significant. Additionally, muni market dynamics typically turn less favorable at this time of year as issuance picks up after a quiet period in the summer. Historically, October has experienced a 39% month-over-month increase in supply and has been the second worst-performing month of the year on average. Long-term investors should keep in mind that seasonal cyclicality is a natural characteristic of the municipal market.

Strategy

Considering expectations for continued interest rate volatility and seasonal weakness in the muni market, we maintain an overall neutral stance on duration (interest rate risk) via a barbell yield curve strategy with concentrations in maturities of 0-5 years and 20 years+. We continue to hold a favorable view on credit and prefer revenue bonds, lower-rated investment grade credits, and issues in high tax states.

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