The Week in Muniland

The slow start to the third quarter continues as geopolitical events further impact fixed-income markets. For the week, two-, 10- and 30-year yields rose 6, 11 and 6 basis points (bps) respectively. The Bloomberg Municipal Bond Index returned –0.40% last week, bringing month-to-date returns to –0.80%. Year-to-date returns now sit at 1.50%.
 

• Why it matters: The muni market remains on solid ground despite the slight giveback in returns this month. Demand totaled $1.4 billion this week, while year-to-date inflows have reached $58.1 billion, continuing to track at the second-highest level on record for the comparable period. Despite the strength of the muni market, global macro events like the Iran conflict can increase volatility. Recall that this year got off to a good start only to stumble in March due to the onset of the Iran conflict. Once the market adjusted, munis had positive performance in April, May and June only to again stumble in July as the conflict in Iran began to heat up. The point being, investors should look to be liquidity providers during times of volatility. Muni yields this month are up between 8 bps and 19 bps with the largest increases in the 10- to 15-year part of the curve. It’s not easy to predict entry points, but when you have a strong technical market that is being impacted by a global macro event causing yields to rise, investors should consider looking to take advantage of a higher-yield environment to position for the eventual rally.
   

As investors find themselves in the midst of volatility, what is the best way to position a muni bond portfolio?
 

• Why it matters: The first thing to do is not panic. During that pullback look to be a liquidity provider. So with that said, how should investors position in today’s environment? There is still value out in the longer end of the yield curve, given its steepness and the value of roll (Display 3). We’re not recommending just to invest in long bonds but rather to pair them with short bonds to build a barbell structure. As seen in Display 1, the short and long ends of the yield curve have been the best performing, with the belly of the curve lagging. Given the recent underperformance within the belly of the curve, there are opportunities to find value. We have recommended to reduce the barbell to take advantage of these opportunities, especially in prepay energy and airport bonds. Especially those airport bonds that are subject to the alternative minimum tax (AMT). The AMT curve is inverted, creating more value in the belly rather than out long. Also, investors should consider investing in short-maturity US Treasuries, if able, given how expensive munis have become on the shorter end of the curve (Display 2). For a more detailed discussion of our outlook and positioning recommendations, see our blog Municipal Midyear Outlook: Room to Run as Demand Drives the Market.
   

The US consumer price index for June was meaningfully lower than expected and lower than recent prints.
 

• Why it matters: Falling oil prices were the primary driver, pulling headline inflation down 0.4% points month over month (MoM). Core inflation was flat on a MoM basis and is up 2.6% YoY, roughly back to where it was before the conflict in Iran. We continue to believe that the Fed will not raise rates, and this print supports that view. It is of course still too early to have complete confidence that the Fed is on hold. It is clear that several members of the Federal Open Market Committee are out of patience with inflation being above target, and oil prices are up 20% so far in July, which will again pull inflation higher in the next release. Still, June’s data should be sufficient to take a July hike off the table and ease concerns that non-energy inflation is steadily moving higher. That’s good news and should buy the Fed some time before it has to take seriously the prospect of a rate hike. Our expectation is that underlying inflation will behave well enough in the next few months for them to keep rates unchanged.