There can be no doubt that the first half of this year has proven to be the most challenging for the municipal market in literally decades. Along the way, market participants and bond investors alike have learned to become adept at making the best of what the market has given … namely, lemons … plenty of lemons.

Given the summer season (a historically strong period for muni market technicals), refreshing lemonade instantly comes to mind. But it is also worth mentioning the pitfalls of those who were too early in harvesting their lemons and why this time may be different. Indeed, much of the new money that entered the market in recent months was often premature and was greeted with further rates-driven losses. Meanwhile, investors who engaged in tax-loss swaps were generally rewarded with abundant supply and significantly higher yields on the replacement bonds of their swaps.

While tax-loss swap activity continues, we believe the right season for enjoying the benefits of investing new cash into now higher yielding bonds (the lemonade) may finally be upon us. Regardless of the analogy used, the opportunity to capture tax-exempt yields that are more than double the levels seen just six months ago should not be ignored … even by otherwise weary market participants given the present volatility. In fact, our alternate title was “Don’t Look Away” (but that seemed a bit dark for the summer).

Let’s look at where we stand. The 10-year AAA muni benchmark yield currently reads 2.39% and was just 1.07% at the start of the year. In terms of relative value, munis remain quite attractive versus corresponding maturity USTs, with 10-year muni relative value residing at approximately 86% after opening the year at just 63% and averaging 67% last year. For context, the 40-year average for 10-year muni relative value is 84%.

 Let’s look at where we stand. The 10-year AAA muni benchmark yield currently reads 2.39% and was just 1.07% at the start of the year. In terms of relative value, munis remain quite attractive versus corresponding maturity USTs, with 10-year muni relative value residing at approximately 86% after opening the year at just 63% and averaging 67% last year. For context, the 40-year average for 10-year muni relative value is 84%.

We believe, however, that this metric should be in the 75% range or lower, given the fact that 15% to +20% of weekly new issuance has been in federally taxable munis, which detracts from what would otherwise be tax-exempt bond supply. Once rate-related volatility moderates, we believe tax-exempt munis should outperform based on this limited tax-exempt supply. Such outperformance could actually occur rapidly, as the 30-Day Visible Supply of new issue bonds set to come to market currently rests at its lowest level since March, according to MMD. In fact, we already had a brief glimpse of sharp outperformance in late June, when 10-year muni yields plummeted 59 basis points, from 3.02% to 2.43% in just nine trading sessions according to MMD. (please see accompanying charts)

Looking ahead, the chart below illustrates Morgan Stanley’s current 10-year US Treasury rate forecast and employs various Muni-to-Treasury relative value relationships to arrive at potential paths for tax-exempts. One year out, there appears to be minimal downside risk from current levels for 10-year munis when applying 84% (the forty-year average) and upside potential for munis when applying both 75% and 65% (approximately last year’s average relative value).

But muni Investors have been whipsawed repeatedly this year … what makes this time different? Aside from the standard “there’s a lot in the price” that investors have been hearing all year, the Fed’s own Summary of Economic Projections (aka “the Dot Plot”) shows the median fed funds rate being mildly lowered in 2024, after peaking at 3.80% next year. Accordingly, there is light at the end of this rapid and bumpy ride through an admittedly dark tunnel. Further, recent rhetoric from Fed Chair Powell suggested that a recession is indeed possible, as they continue to front-load their battle against stubbornly high inflation. This admission fueled budding speculation that the Fed may not accomplish all the hikes that they have signaled. And … there is a lot already in the price.

As we prepare this note, the yield spread between 2-year USTs and 10-year maturity USTs is already inverted by 19 basis points, while the same yield curve for munis is not inverted, at positive 69 basis points. Indeed, there is likely to be much chatter in the bond market about inverted yield curves over the coming months while the Fed enacts further rate hikes. In fact, Morgan Stanley’s US Interest rate forecast calls for a 50-basis point inversion, with 2-yr USTs ending this year at 4% and 10- year USTs at 3.50%. However, it is worth noting that the muni market may not play along, as tax-exempts have not inverted in at least 40 years, which is how far back electronic records are available, according to MMD. (please see the accompanying chart)

That said, we see the muni market as being “inversion-resistant”, rather than “inversion-proof.” Similar to a fine watch that is “water-resistant” to a depth you would be unlikely to surpass, but not necessarily “water-proof” to all depths, the tax-exempt muni yield curve is unlikely to invert given the extreme volatility we have seen so far, but it’s not impossible. We attribute this inversion-resistance to the unique, primarily individual investor buyer base of the tax-exempt muni market, a base that is generally reluctant to extend beyond ten-year maturities in the calmest of markets (which this certainly is not) and prone to “stay short” during times of market uncertainty, which abounds.

This primarily individual investor buyer base is also a key driver behind the muni market’s inability to materially outperform USTs year-to-date. Persistent and sizable weekly outflows from muni mutual funds have repeatedly thwarted positive market sentiment, but now these negative flows seem to be slowing to more manageable trend. (please see accompanying chart)

Pulling it all together, we appear to be reaching a point where the bond markets may be more equally weighing both the near-term market impacts of this accelerated rate-hiking cycle AND the prospect of the resulting economic slowdown/recession. With this is mind and acknowledging the bond markets’ tendency to overreact in both directions, our suggestion for prospective muni buyers during what could be an extended range-bound environment is to keep an eye on both muni relative value and absolute UST yields … considering purchasing when 10-year muni relative value exceeds 80% and/or when 10-year UST yields are near or above 3%. Enjoy your summer!

Risk Considerations

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Municipal securities are subject to early redemption risk and sensitive to tax, legislative and political changes. Taxability Risk. Changes in tax laws or adverse determinations by the Internal Revenue Service (“IRS”) may make the income from some municipal obligations taxable. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company’s portfolio securities. In addition to the Portfolio’s fees and expenses, the Portfolio generally would bear its share of the investment company’s fees and expenses.