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MARKETS
13 February 2024

Weekly Municipal Monitor—Diverging Valuations

By Sam Weitzman
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Municipals Posted Negative Returns Last Week

Munis posted negative returns but outperformed Treasuries during a volatile week that saw regional banking challenges and the Fed keeping rates unchanged, but noting that additional progress on inflation is required before easing policy. High-grade muni yields moved 10-17 basis points (bps) higher across the curve. Meanwhile, market technicals waned with fund outflows and higher supply conditions. The Bloomberg Municipal Index returned -0.45% during the week, the High Yield Muni Index returned -0.50% and the Taxable Muni Index returned -0.97%. This week we highlight diverging valuations between top-quality munis and credit-oriented counterparts.

Muni Technicals Waned on Fund Outflows, Higher Supply Conditions

Fund Flows: During the week ending February 7, weekly reporting municipal mutual funds recorded $121 million of net outflows, according to Lipper. Long-term funds recorded $61 million of outflows, high-yield funds recorded $347 million of inflows and intermediate funds recorded $44 million of inflows. Short-term funds posted outflows of $83 million. This week’s outflows led estimated year-to-date (YTD) net inflows lower to $2 billion.

Supply: The muni market recorded $10 billion of new-issue volume last week, down 78% from the prior week. YTD issuance of $44 billion is 76% higher from last year’s level, with tax-exempt issuance 84% higher and taxable issuance 5% lower year-over year. This week’s calendar is expected decline to $6 billion. Largest deals include $682 billion Kentucky Public Energy Authority and $400 million Prosper TX Independent School District transactions.

This Week in Munis: Diverging Valuations

AAA Municipal-to-Treasury ratios are perhaps the most widely used metric to determine if the municipal asset class offers relative value to other taxable fixed-income assets. As the 10-year AAA Muni/Treasury ratio has fallen to near record low levels this year, market participants might be considering holding off allocating to municipals at potentially “relatively rich” valuations.

Exhibit 1: 10-Year AAA Municipal Treasury Ratio
10-Year AAA Municipal Treasury Ratio
Source: Bloomberg. As of 09 Feb 24. Select the image to expand the view.

Prior to the global financial crisis (GFC), the 10-Year Muni/Treasury ratio may have been a more relevant metric for the municipal asset class, but today AAA munis comprise a small portion of the overall muni market. In 2007, 70% of munis in the index held a AAA rating on a stand-alone basis, or by virtue of insurance. Following the downgrade of bond insurers after the GFC and subsequent transformation of the muni market to a credit market, AAA munis comprise only 12% of the Bloomberg Municipal Bond Index and even fewer mature within the 10-year maturity tenor.

Exhibit 2: AAA Percentage of the Bloomberg Muni Bond Index
AAA Percentage of the Bloomberg Muni Bond Index
Source: Bloomberg. As of 09 Feb 24. Select the image to expand the view.

Since the municipal market evolved to a credit market, valuations could be better sought versus comparable corporate bond indices. The AA, A and BBB credit-oriented components of the municipal index together comprise 88% of the Bloomberg Municipal Bond Index. When considering the after-tax yield pickup between like-rated municipal and corporate indices, AA, A and BBB municipals currently offer an after-tax yield pickup that is 36-109 bps higher versus comparably rated corporates, all exceeding five-year averages for top taxpayers.

Exhibit 3: After-Tax Yield Pickup vs. the 5-Year Average
After-Tax Yield Pickup vs. the 5-Year Average
Source: Bloomberg. As of 09 Feb 24. Select the image to expand the view.

While short- and intermediate-term AAA Municipal/Treasury ratios are undeniably at near record lows, today AAA municipals comprise just a small minority of the municipal market. Western Asset attributes the relatively tighter shorter-term ratios to elevated separately managed account (SMA) demand that maintain guidelines that bias investment into higher quality shorter tenors. Meanwhile, credit-oriented segments that now comprise the majority of the market still offer above-average after-tax yield pick-up versus comparably rated corporates. Whether positioning within a fund or separate account vehicle, Western Asset believes muni investors seeking risk-adjusted value are better served with flexibility to access the broader credit spectrum at current valuations.

Exhibit 4: Muni Credit Curves
Muni Credit Curves
Source: Bloomberg, Western Asset. As of 09 Feb 24. Bloomberg BVAL Municipal Credit Indices (AAA, AA, A, BBB, respectively) and US Sovereign Curves. Taxable-Equivalent Muni Credit Curves consider the top marginal effective tax rate of 40.8%. Select the image to expand the view.
Exhibit 5: Taxable-Equivalent Muni Credit Curves
Taxable-Equivalent Muni Credit Curves
Source: Bloomberg, Western Asset. As of 09 Feb 24. Bloomberg BVAL Municipal Credit Indices (AAA, AA, A, BBB, respectively) and US Sovereign Curves. Taxable-Equivalent Muni Credit Curves consider the top marginal effective tax rate of 40.8%. Select the image to expand the view.
Exhibit 6: AAA Munis versus Treasuries
AAA Munis versus Treasuries
Source: Bloomberg. As of 09 Feb 24. Past performance is not a guarantee of future results. It is not possible to invest directly in an Index. Select the image to expand the view.
Exhibit 7: Tax-Exempt and Taxable Muni Valuations
Tax-Exempt and Taxable Muni Valuations
Source: Bloomberg. As of 09 Feb 24. Select the image to expand the view.

Western Asset Key Themes for Muni Investors

Theme #1: Municipal taxable-equivalent yields are above decade averages.

Exhibit 8: Muni and Taxable-Equivalent Muni Yield-to-Worst
Muni and Taxable-Equivalent Muni Yield-to-Worst
Source: Bloomberg, Western Asset. As of 09 Feb 24. Bloomberg Municipal Bond Index Yield Considering Highest Marginal Tax Rate. Select the image to expand the view.

Theme #2: Recent yield curve steepening has highlighted value in longer maturities.

Exhibit 9: AAA Municipal vs. Treasury Yield Curves
AAA Municipal vs. Treasury Yield Curves
Source: Bloomberg, Western Asset. As of 09 Feb 24. Bloomberg BVAL AAA Muni Curve and US On-/Off-the-Run Sovereign Curve. Select the image to expand the view.

Theme #3: Munis offer attractive after-tax yield pickup versus long Treasuries and corporate credit.

Exhibit 10: Municipal vs. Taxable Fixed-Income Yields by Quality
Municipal vs. Taxable Fixed-Income Yields by Quality
Source: Western Asset, Bloomberg. As 09 Feb 24. Bloomberg BVAL AAA Muni Curve and US On-/Off-the-Run Sovereign Curve. After-tax yield considers top marginal tax rate of 40.8%. Select the image to expand the view.

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