skip navigation
Blog

Stay up to date on timely topics and market events. Subscribe to our Blog now.

MARKETS
27 September 2022

Weekly Municipal Monitor—Challenged Conditions Continue

By Rolf E. Lundelius, PhD
Download the Article

Stay up to date on timely topics and market events. Subscribe to our Blog now.

Municipals Posted Negative Returns

Municipals posted negative returns last week as rates moved higher with Treasuries. High-grade municipal yields moved 12-43 bps across the curve. Meanwhile, fund outflows continued amid a limited supply calendar. The Bloomberg Municipal Index returned -1.35% and the HY Muni Index returned -1.98%. This week we highlight challenged market conditions that could contribute to near-term market volatility.

Last Week’s New-Issue Calendar Was Limited as Fund Outflows Continued

Fund Flows: During the week ending September 21, weekly reporting municipal mutual funds recorded $2 billion of net outflows, according to Lipper. Long-term funds recorded $1.3 billion of outflows, high-yield funds recorded $567 million of outflows and intermediate funds recorded $217 million of outflows. The week’s outflows extend year-to-date (YTD) outflows to $88 billion.

Supply: The muni market recorded $2 billion of new-issue volume, down 78% from the prior week. Total YTD issuance of $287 billion is 12% lower than last year’s levels, with tax-exempt issuance trending 2% lower year-over-year (YoY) and taxable issuance trending 44% lower YoY. This week’s new-issue calendar is expected to increase to $8 billion. Larger deals include $1.4 billion New York State UDC Personal Income Tax and $985 million Texas Water Development Board transactions.

This Week in Munis: Challenged Conditions Continue

Last month we highlighted the rising-rate conditions and elevated rate volatility that roiled the municipal markets throughout much of this year. While there were signs that declining rates and declining market volatility in July could lead to market stabilization, a return of rising rates and persistently high rate volatility in August and September have contributed to weak market conditions that again warrant caution.

Municipal yields sharply increased with Treasuries. Since our post in August, the 10-year municipal yield increased sharply from 2.14% to 2.85%, the highest level since September 2013. Notably, municipal yields had either lagged or overshot the path of Treasury rate increases from 2020 through the 1H22. However, in August and September, muni rate increases have been more correlated to Treasuries, signaling that forward-looking muni performance could be more dependent on Treasury rates in the back half of the year.

Exhibit 1: 10-Year AAA Muni vs. 10-Year Treasury Yield
Explore 10-Year AAA Muni vs. 10-Year Treasury Yield
Source: Thomson Reuters, Bloomberg. As of 23 Sep 22. Select the image to expand the view.

Elevated rate volatility could further challenge market technicals. Municipal rate volatility began to decline in July, but remains well above historical averages. While we have observed municipals typically outperform high quality fixed-income during rising-rate periods, municipal demand tends to wane during periods of heavy rate volatility. For a market increasingly dependent on supply and demand technicals, a rebound of municipal demand appears to remain contingent on stabilizing rate volatility.

Exhibit 2: 10-Year AAA Muni Rate Volatility vs. Weekly Fund Flows
Explore 10-Year AAA Muni Rate Volatility vs. Weekly Fund Flows
Source: Thomson Reuters, Bloomberg. As of 23 Sep 22. Select the image to expand the view.

Negative price action has compounded structural vulnerabilities. The aggressive move in both rates and rate volatility has rightfully challenged municipal valuations. The majority of the municipal securities include embedded call options. As rates rise, the probability that a bond will be called will decline, and as such, the underlying bond’s price will decline so that the yield and duration reflect the respective yield-to-maturity and maturity date, rather than the yield-to-call and the call date. For lower-coupon municipal issues, these price declines are compounded as a portion of a bond’s accretion can be subject to ordinary income tax per de minimis regulations.

Rising municipal rates have certainly offered better relative value opportunities for municipal investors. However, we anticipate an uncertain inflationary environment, elevated rate volatility and structural risks that have re-emerged in the past two months to warrant caution within a municipal allocation. We believe portfolio flexibility is key in this climate, and active managers that seek to value these risks and opportunities stand to benefit during these periods of extended market volatility.

Exhibit 3: Municipal Bond Yields and Index Returns
Explore Municipal Bond Yields and Index Returns
Source: Bloomberg. As of 23 Sep 22. Select the image to expand the view.
Exhibit 4: Tax-Exempt and Taxable Muni Valuations
Explore Tax-Exempt and Taxable Muni Valuations
Source: Bloomberg. As of 23 Sep 22. Select the image to expand the view.
© Western Asset Management Company, LLC 2024. The information contained in these materials ("the materials") is intended for the exclusive use of the designated recipient ("the recipient"). This information is proprietary and confidential and may contain commercially sensitive information, and may not be copied, reproduced or republished, in whole or in part, without the prior written consent of Western Asset Management Company ("Western Asset").
Past performance does not predict future returns. These materials should not be deemed to be a prediction or projection of future performance. These materials are intended for investment professionals including professional clients, eligible counterparties, and qualified investors only.
These materials have been produced for illustrative and informational purposes only. These materials contain Western Asset's opinions and beliefs as of the date designated on the materials; these views are subject to change and may not reflect real-time market developments and investment views.
Third party data may be used throughout the materials, and this data is believed to be accurate to the best of Western Asset's knowledge at the time of publication, but cannot be guaranteed. These materials may also contain strategy or product awards or rankings from independent third parties or industry publications which are based on unbiased quantitative and/or qualitative information determined independently by each third party or publication. In some cases, Western Asset may subscribe to these third party's standard industry services or publications. These standard subscriptions and services are available to all asset managers and do not influence rankings or awards in any way.
Investment strategies or products discussed herein may involve a high degree of risk, including the loss of some or all capital. Investments in any products or strategies described in these materials may be volatile, and investors should have the financial ability and willingness to accept such risks.
Unless otherwise noted, investment performance contained in these materials is reflective of a strategy composite. All other strategy data and information included in these materials reflects a representative portfolio which is an account in the composite that Western Asset believes most closely reflects the current portfolio management style of the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from other accounts in the composite. Information regarding the representative portfolio and the other accounts in the composite are available upon request. Statements in these materials should not be considered investment advice. References, either general or specific, to securities and/or issuers in the materials are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendation to purchase or sell such securities. Employees and/or clients of Western Asset may have a position in the securities or issuers mentioned.
These materials are not intended to provide, and should not be relied on for, accounting, legal, tax, investment or other advice. The recipient should consult its own counsel, accountant, investment, tax, and any other advisers for this advice, including economic risks and merits, related to making an investment with Western Asset. The recipient is responsible for observing the applicable laws and regulations of their country of residence.
Founded in 1971, Western Asset Management Company is a global fixed-income investment manager with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Zürich. Western Asset is a wholly owned subsidiary of Franklin Resources, Inc. but operates autonomously. Western Asset is comprised of six legal entities across the globe, each with distinct regional registrations: Western Asset Management Company, LLC, a registered Investment Adviser with the Securities and Exchange Commission; Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Brazilian Central Bank; Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services License 303160; Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services License for fund management and regulated by the Monetary Authority of Singapore; Western Asset Management Company Ltd, a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan; and Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority ("FCA") (FRN 145930). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK as defined by the FCA. This communication may also be intended for certain EEA countries where Western Asset has been granted permission to do so. For the current list of the approved EEA countries please contact Western Asset at +44 (0)20 7422 3000.