Municipal bonds | Insight Investment

Market review

For July, AAA-rated tax-exempt municipal bond performance was positive in the short and medium portions of the curve and negative for longer duration. The high-grade tax-exempt yield curve steepened, while the Treasury yield curve flattened slightly. The ratio of AAA-rated tax-exempt municipal yields to US Treasury yields was tighter across the short and middle portions of the curve and slightly wider on the long end. The yield ratios decreased by 6 ratios in five years, decreased 1 ratio in ten years and increased 1 ratio in thirty years.

The best performing states were Puerto Rico, New Mexico and Montana. The weakest performers were Rhode Island, Wyoming and Arkansas. The highest outperforming revenue sectors were IDR/PCR, Resource Recovery and Tobacco, while the weakest performers were Hospitals, Housing and Special Tax. By quality, AA-rated municipals were the strongest performers, followed by A, AAA and BBB-rated municipals, respectively. 

The US Agg-eligible taxable municipal index generated a total return of -0.16%. Spreads for the taxable municipal index tightened by 5bps and spreads for the credit long index tightened by 6 bps.

Monthly municipal issuance was $53bn, above the average for the month over the past 5 years. Taxable municipal issuance represented just 4% of July’s supply.

Muni fund flows were positive for July, with inflows averaging $650m per week. ETF fund flows were negative for July, with outflows averaging $386m 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.

We continue to forecast a softening 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 may follow the trend in Treasuries with the prospect of more yield curve steepening.

From a sector perspective we favor revenues such as public power and water/sewer utilities, which offer 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 duration to be neutral to slightly long versus respective benchmarks. The considerable 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.