Municipal bonds | Insight Investment

Market review

For April, AAA-rated tax-exempt municipal bonds posted negative returns across the yield curve with shorter-dated maturities performing the best. The high-grade tax-exempt yield curve flattened, while the Treasury yield curve both steepened. The ratio of AAA-rated tax-exempt municipal yields to US Treasury yields was higher across the curve with municipals underperforming compared to Treasuries. Yield ratios increased by nine ratios in five years, increased 3 ratios in ten years and increased two ratios in thirty years.

The best performers included the Virgin Islands, Puerto Rico and Mississippi. The weakest performers were Guam, South Carolina and Alaska. The highest outperforming revenue sectors were Special Tax, Housing and Water & Sewer, while the weakest performers were Resource Recovery, Hospital and Leasing. By quality, AAA-rated municipals were the strongest performers, followed by AA, A and BBB-rated municipals, respectively. 

The US Agg-eligible taxable municipal index generated a total return of -0.20%. Spreads for the taxable municipal index widened by 5 bps and spreads for the credit long index widened by 13 bps.

Monthly municipal issuance was $45bn, above the average for the month over the past 5 years. Taxable municipal issuance represented 10% of April’s supply.

Muni fund flows were negative for April, with outflows averaging $900m per week. ETF fund flows were positive for April, with inflows averaging $600m per week.

Outlook

Municipal credit conditions remain solid as we enter an uncertain post-election period. For the state and local tax-backed sectors, the resiliency of credit conditions is supported by very high reserves and cash balances that have accumulated over the last few years. Nevertheless, number of risk factors remain, including softening economic conditions that could be exacerbated by government policies, persistently high labor expenses, and rising property insurance costs associated with increasing natural disasters and their potential impact on home prices and migration.

Our 2025 outlook calls for resilience of the U.S. economy and slight moderating of inflation. The heightened uncertainty surrounding the new Trump administration’s policies, some of which may be inflationary, is likely to keep pressure on longer maturity rates. Municipal yields should follow the trend in Treasuries with the prospect of more yield curve steepening.

From a sector perspective we favor revenue bonds such as public power and water/sewer utilities, which have offered stability due to their independent rate setting ability, essentiality, and relatively predictable cash flows. We are generally underweighting sectors that offer less yield premium such as state and local general obligation and pre-refunded bonds. Credit spreads have compressed significantly in recent years and may have room to run further given a solid fundamental credit backdrop and steady demand prospects for municipal bonds.

We continue to see good value in airport and toll road credits due to the recovery of air and vehicular travel respectively to pre-pandemic levels. Mass transit remains challenged due to work-from-home arrangements, although we are seeing some momentum toward returning to office. Healthcare is facing headwinds from rising labor and equipment costs, while higher education is strained by weakening demographic trends and tuition affordability concerns. On balance, we prefer to focus on large, geographically diversified issuers with strong balance sheets, which are able to withstand temporary periods of economic weakness. The increasing frequency and magnitude of natural disasters such as hurricanes, flooding, and wildfires, in combination with strained federal funding for disaster relief, highlights the importance of considering physical climate risks.

In the near term, we are targeting a duration position that is neutral to slightly long versus our respective benchmarks. This positioning is intended to capture the expected positive seasonal technical trends in the second quarter, driven by heavy reinvestment flows, which should help in contending with continued heavy new issue supply. The recent steepening of the municipal yield curve toward an upward slope has increased the incentive for investors to extend duration and capture attractive incremental yield in the face of some Fed easing towards the second half of the year. The prospect for higher inflationary impacts from fiscal and tariff policy of the new administration may drive a more bearish steepen environment longer term as long rates could be pressured higher.