The Week in Muniland

The muni market found some stability this week following the Fed raising its target rate. The muni yield curve flattened, with two- and 10-year AAA yields up 19 and 5 basis points (bps), respectively, while the 30-year yield was flat. The Bloomberg Municipal Bond Index (the Index) returned –0.31% last week, bringing year-to-date returns to –1.86%.
 

• Why it matters: We believe munis are cheap, both on an absolute and relative basis. They may get cheaper, but that’s not a certainty, which is why we’ve been recommending that investors consider dollar-cost averaging into munis. Why do we view munis as cheap? To start, the price of the Index is below par at $98.17, while its yield has risen to 4.37%, translating to a taxable-equivalent yield (TEY) of 7.38%. The last time the Index yield was this high was back in August 2001. The Muni High Yield Index has a TEY of 9.98% versus 7.73% of the Corporate High Yield Index! Even the 10-year AAA muni yield is at a near 10-year high (Display 1). Munis have become significantly more attractive relative to US Treasuries (Display 2), while the long end of the yield curve, specifically the 10- to 14-year range, offers meaningful roll potential of nearly 100 bps (Display 3). We’ve seen prior periods when munis sold off. Most recently was August–October 2023 when the Index was down 5.2%, only to rally 8.7% in November–December. For these reasons, we suggest investors consider leaning into a down market, not running away.
   

The Federal Open Market Committee (FOMC) raised its target rate by 25 bps to range of 3.75%–4.00%, as had been widely expected.
 

• Why it matters: In addition, the decision to hike was unanimous. Looking at the dot plot, the dots make clear that the committee views this as an adjustment, not the start of a prolonged hiking cycle. To that point, no FOMC member expects more than 75 bps of hikes in total, and all members see the neutral rate settling between 3% and 4%. Chair Kevin Warsh’s own language backs this up, stating that its move is meant to “support a timelier return to the committee’s 2% goal.” That is an adjustment, not a shift in regime. Our expectation is for one more hike, likely in December, before underlying inflation slows enough for the Fed to go back on hold. But the path depends on the next few months of data: persistent oil-driven price pressure could push the Fed to hike more than expected, while a faster cooling in prices could mean last week’s move was the last one needed. We see those risks as roughly balanced. Warsh also stressed that it’s the medium-term trend in inflation, not any single month’s print, that will guide the committee from here—though the market may take that with some skepticism given how much weight the August CPI data appeared to carry in today’s decision.
   

While recent volatility certainly creates opportunities for tax-loss harvesting, a bond trading at a loss isn’t automatically a bond worth selling.
 

• Why it matters: We recommend investors utilize a calculated framework when realizing losses. For example, consider the tax benefit—the tax lot capital loss multiplied by a specific investor’s tax rate. A higher benefit makes a security more attractive to sell, all else equal. In addition, investors should consider the replacement opportunity, with the goal being to increase the portfolio’s expected return by harvesting a tax loss and reinvesting in a bond with a higher expected return. The bigger the increase, the more attractive it is to sell. Finally, what about transaction costs? A bond’s size, credit rating and duration all affect what it costs to sell, and that cost can rise during volatile markets. Taken together, these factors—not the headline loss—are what should drive the decision, in our view.