The Week in Muniland

The Iran conflict along with elevated supply continue to rattle the muni market. For the week, two-, 10- and 30-year yields rose 18, 22 and 19 basis points (bps), respectively. The Bloomberg Municipal Bond Index returned –1.19% last week, bringing month-to-date returns to –1.98%. Year-to-date returns now sit at 0.30%.

• Why it matters: July feels eerily similar to March. With the onset of the Iran conflict, the muni market was down 2.32% (Display 1). The market settled down from April through June, only to sell off again in July as the conflict began to intensify. For the month, muni yields have increased 26–41 bps with the largest increases in the 10- to 15-year parts of the curve. Munis underperformed US Treasuries (USTs) in July and have thus materially cheapened (Display 2). As we enter August, the market could be in a better place from a supply and demand perspective, as net supply is expected to be flat. Typically, when supply and demand technicals are in an investor’s favor, performance tends to be positive. New issue supply has surprised on the high end, so August is not yet a forgone conclusion. Nevertheless, with yields materially higher, munis relatively cheaper and August reinvestment about to hit the market, there is a case to be made that munis will settle down.
  
  

Investors tend to get spooked during periods of volatility. During these periods, how should investors respond? Hold, sell or invest?

• Why it matters: It’s not easy to predict entry points, but when you have a strong technical market that is being primarily impacted by a global macro event and causing yields to rise, investors should consider taking advantage of the higher-yield environment. The beauty of bonds is that they’re math, which means you know what your return will be at the time you invest if you hold that bond to its maturity. So if investors can look through the month-tomonth volatility, they should let their yield be the engine of returns. Today, the horsepower in a bond portfolio is greater than it was at the beginning of the month. What that does is provide more income, higher return potential and greater downside protection against future yield increases (Display 4). What we recommend is that investors be liquidity providers during periods of volatility by investing in higher-yielding bonds—not necessarily investing every dollar, but dollar-cost averaging into the higher-yielding market. The thought is that a potentially stronger technical market in August coupled with the relatively attractive muni market should provide stability. Also, investors should be looking to harvest losses in their bond portfolios. Given this month’s sell-off, there are likely opportunities to take advantage by selling losses, increasing book yields and accumulating tax-loss carryforwards.
  
  

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

• Why it matters: Consider adding duration. Bond yields just jumped as much as 41 bps in three weeks. The market will find calm waters; when it does, duration will likely outperform as it has throughout the course of this year. In our opinion, there is still value in the longer end of the yield curve, given its steepness and the value of roll (Display 3). We’re not recommending investing in only long bonds but rather pairing them with short bonds to build a barbell structure. 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, there are opportunities to find value. We have recommended reducing the barbell to take advantage of these opportunities, most notably 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. We have also recommended that investors consider investing in short-maturity USTs, if able, given how expensive munis had become. Since munis have recently underperformed USTs, that trade has been successful.