Municipal bonds | Insight Investment

Market review

In May, AAA-rated tax-exempt municipal bonds posted positive returns at the short and intermediate portion of the yield curve with the 6-8 year and 4-6 year indices performing the best. The high-grade tax-exempt yield curve steepened, while the Treasury yield curve flattened. The ratio of AAA-rated tax-exempt municipal yields to US Treasury yields was tighter across the curve with municipals outperforming compared to Treasuries. Yield ratios decreased by 10 ratios in five years, decreased five ratios in 10 years and decreased 2 ratios in 30 years.

The best performing states were the Puerto Rico, New Mexico and Connecticut. The weakest performers were Arkansas, South Dakota and Guam. The highest outperforming revenue sectors were IDR/PCR, Tobacco and Resource Recovery, while the weakest performers were Hospitals, Special Tax and Water & Sewer. 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 -1.48%. Spreads for the taxable municipal index tightened by 3 bps and spreads for the credit long index tightened by 18 bps.

Monthly municipal issuance was $50bn, above the average for the month over the past five years. Taxable municipal issuance represented 6% of May’s supply.

Muni fund flows were positive for May, with inflows averaging $775m per week. ETF fund flows were positive for May, with inflows averaging $1bn per week.

Outlook

Municipal credit conditions remain solid. 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, a 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 a softening US 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 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, which should help capture an expected positive seasonal technical backdrop during the first quarter with heavy reinvestment flows and limited 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.