Weekly Municipal Monitor—Munis and Fed Rate Hikes

Blog

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

Municipals Posted Positive Returns During the Week

US municipals posted positive returns during the week on a flight-to-quality sentiment as high-grade municipal yields moved 4-5 bps lower across the curve. Municipals outperformed Treasuries as Municipal/Treasury ratios declined. The technical environment remained soft amid continued mutual fund outflows and an uptick in new-issue supply. The Bloomberg Municipal Index returned 0.17%, while the HY Muni Index returned 0.10%. This week we highlight historical municipal performance during Federal Reserve (Fed) hiking cycles.

Municipal Technicals Remained Soft as Municipal Fund Outflows Continued

Fund Flows: During the week ending February 23, weekly reporting municipal mutual funds recorded $1.2 billion of net outflows, according to Lipper. Long-term funds recorded $525 million of outflows, high-yield funds recorded $283 million of outflows and intermediate funds recorded $262 million of outflows. Municipal fund outflows year to date (YTD) extended to $8.3 billion.

Supply: The muni market recorded $10 billion of new-issue volume, over double the prior week’s level. Total YTD issuance of $58 billion is 17% higher from last year’s levels, with tax-exempt issuance trending 48% higher year-over-year (YoY) and taxable issuance trending 50% lower YoY. This week’s new-issue calendar is expected to drop to $4.0 billion. The largest deals include $793 million New York City Municipal Water Authority and $570 million Department of Water and Power of the City of Los Angeles transactions.

This Week in Munis: Munis and Fed Rate Hikes

Municipal market volatility observed this year has been driven by inflation and rising-rate concerns. While rising rates can weigh on fixed-income prices, we believe it is important for investors to recognize that the impact of rising rates is often offset by the income component of total returns, and do not automatically translate to negative total returns. In addition, the tax-exemption associated with the municipal asset class offers a unique structural benefit that becomes more valuable as rates increase. For every 100 bps of higher yields in a taxable asset, tax-exempt municipal yields should increase at a lower rate to maintain after-tax income equilibrium, often limiting negative price pressures associated with the muni asset class when rates rise. To further demonstrate these trends, we evaluate muni performance across the past three Fed Funds Rate hiking cycles that took place over the last 25 years, beginning in 1999, 2004 and 2015.

Municipals have outperformed other high quality fixed-income over the past two Fed hiking cycles. Over the past three hiking cycles, US investment-grade fixed-income posted positive total returns as the income component of returns more than offset price pressures associated with rising rates. On a tax-adjusted return per unit of duration basis (assuming a conservative 21% tax rate), municipals outperformed high-grade taxable fixed-income during the last two of these hiking cycles starting in 2004 and 2015.

Explore 1999-2018 Rising Rate Periods—Adjusted Sector Returns

Within the municipal sector during Fed rate hiking cycles, we observe correlated performance trends. From a curve perspective, highest duration-adjusted returns were recorded within the intermediate part of the curve during all three Fed hiking periods. From a credit-quality standpoint, A rated municipals outperformed both higher quality and lower quality counterparts during the two most recent Fed hiking periods beginning in 2004 and 2015.

Explore 1999-2018 Rising Rate Periods—Municipal Sectors

Considering the currently low Fed Funds Rate (upper target: 0.25%) as a starting point, paired with the potential that above-average inflation could lead to a potentially longer hiking cycle, we believe that the upcoming Fed hiking cycle could exhibit characteristics closer to 2004 and 2015 rather than what was observed in 1999. In this scenario, we could anticipate munis to perform well versus other taxable investment-grade fixed-income sectors, and that intermediate munis within the mid-investment-grade quality cohort could prove particularly resilient. As highlighted in these prior scenarios, we would expect the municipal asset class to serve as ballast of an asset allocation amid potential broader market volatility, and that an active manager can consider these performance trends to deliver value in the upcoming environment.

Note that this information does not constitute investment advice or recommendations with respect to the sectors listed and should not be the sole basis for any investment decision. Past performance is not indicative of future results.

Explore Municipal Bond Yields and Index Return

© 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.