What’s Behind Municipal Bonds’ Recent Volatility? | Lord Abbett
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Fixed-Income Insights

Concerns about rates and supply/demand factors have weighed on municipal bonds in recent weeks, but we expect that longer-term market fundamentals will remain positive

Read time: 4 minutes

After strong performance during the first half of 2021 and a stable summer, the municipal bond market has become more volatile since Labor Day. With good performance since the early months of the pandemic, many want to know the reasons for the change in tone.

The primary reason is the rise in U.S. Treasury rates, but the recent volatility is also somewhat due to technical factors specific to the municipal bond market.  Here, we’ll take a closer look at what is driving the volatility.

Issuer Credit and Interest Rates

One point we consistently make is that the municipal bond market is heavily influenced by the sentiment of retail investors. According to Federal Reserve data, almost 70% of the outstanding municipal bonds are owned by individuals either through professionally managed products or brokerage accounts.  The two primary reasons why retail investors periodically become skittish is (1) if there are credit problems among muni issuers or (2) if interest rates rise.

Now, credit is doing well with the U.S. economy rebounding faster than forecasted since the pandemic started and fiscal stimulus adding cash to balance sheets in many sectors.  On the other hand, interest rates have been rising somewhat and forecasts are uncertain about future moves in Treasury yields, creating a degree of uncertainty among investors. This is the major issue impacting the market.

On August 3, the 10-year Treasury yield was 1.17% while on October 7 it stood at 1.56%.  While today’s rates are still low compared to history, they have risen significantly over a short period of time. If this rate increase happened slowly over a year, the total return numbers would look better because they would include more months of income. In this case, with only two months of income, total returns have been negative for bondholders. For example, the Bloomberg Municipal Bond Index had a total return of -0.72% for September but is still positive for the first nine months of the year at 0.79%. The Bloomberg High Yield Municipal Bond Index was down -0.65% for September but is up 6.53% year-to-date through October 7.

For most of the summer, yields for municipals barely moved even though the Treasury and stock markets were volatile. (See Figure 1; the red line represents 10-year Treasury yields, while the blue line shows benchmark yields for ‘AAA’-rated municipal bonds.)

 

Figure 1. After a Stable Summer, Muni Yields Have Mirrored Similar Moves in U.S. Treasuries
Yields for AAA-rated municipal bonds and 10-year U.S. Treasury notes, October 7, 2020-October 7, 2021

Source: Bloomberg. Data as of October 7, 2021. AAA-rated municipal bonds are represented by the BVAL Municipal AAA Yield Curve, which is populated with high-quality U.S. municipal bonds with an average rating of AAA from Moody’s and S&P; 10-year U.S. Treasuries are represented by the US Generic Government 10-Year Index, a sovereign generic index used as a proxy for 10-year U.S. Treasury notes..

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

For example, 30-year benchmark AAA yields set daily by Municipal Market Data did not change on 26 days during July and August including a stretch of nine consecutive days in the latter month. Often, municipal yields don’t move on short term Treasury volatility, but instead move later after the trend becomes more consistent. With the Federal Reserve (Fed) signaling that it is likely to start tapering soon, and investors uncertain whether recent increases in inflation are transitory, the outlook is less certain than it was earlier this year. Still, to take the other side of the issue, COVID-19 is still spreading around the world, economies are not back to pre-pandemic levels in many sectors, supply chain issues are likely to be resolved in the not-too-distant future, interest rates remain very low around the world, and many countries are way behind the United States in responding to the pandemic. So, there are a lot of factors that could keep a cap on how high rates might go.

Supply/Demand Factors

That is the macro-level reason for the change in the tone of the municipal bond market. At the market level, the main factors have been the changes in supply and demand of municipal bonds since the summer.  On the supply side, new tax-exempt municipal bond issuance ranges around $7 billion to $8 billion a week. Over the past month, weekly new issue supply has been elevated to approximately $11 billion. (See Figure 2.) This is typical for this time of the year, but still it puts more pressure on the market as these new issues need to be sold in competition with each other.

 

Figure 2.  Municipal Bond Issuance Has Been on a Tear in 2021
Weekly new issuance of municipal bonds in 2021 (through October 7)

Source: Bloomberg. Data as of October 7, 2021.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

As for the demand side, as rates have been rising, retail investors have been putting less money into municipal bond mutual funds. For 2021, the total cumulative fund inflows are the second highest on record for a year at approximately $88 billion, but after seeing approximately $1.5 billion to $2 billion per week for most of the year, the number has fallen to under $500 million recently. (See Figure 3.) Many portfolio managers have also been conservative in keeping higher cash balances as rates have been rising, so that is also slowing some demand for the new bonds. While fund flows are still positive, the combination of increased supply and reduced demand is putting pressure on the market at a time when interest rates are rising.

 

Figure 3. Rising Yields, Supply/Demand Factors Have Dampened Recent Muni-Bond Fund Flows
Weekly municipal bond fund flows (million US$), January 6, 2021–October 6, 2021

Source: Lipper. Data as of October 6, 2021 for U.S.-registered municipal bond mutual funds.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Meanwhile, there don’t appear to be any significant concerns for municipal bonds on the credit front. Rating agencies have been upgrading sector outlooks which they lowered last year so that just about all sectors are now on stable or positive outlooks. Defaults remain low, and the small number that do occur are only hitting small pockets of the high yield muni market such as senior living.  Many credits kept strong balance sheets going into the pandemic, saw rebounds in revenues faster than expected and got stimulus money to support them through uncertain times. The tightening credit spreads reflect the positive outlook on credit, as Figure 4 shows.

 

Figure 4. Municipal Bond Credit Spreads Have Tightened
Spread between the Bloomberg High Yield Municipal Bond Index and the Bloomberg Municipal Bond Index, May 4, 2018-August 7, 2021

Source: Bloomberg. Data as of October 7, 2021.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Any municipal bond market update must also include what is going on in Washington, because Congress is considering many items in current infrastructure bills that could affect the market. The top one is that we know tax rates are not going down. It is possible they may go up for corporations or high-income individuals, but nothing has been decided yet. We could see more new issue supply if tax legislation brings back tax-exempt advance refundings, but that is uncertain and more new issue supply might be positive as it could provide more investable opportunities. Although things could change, most information so far suggests that any proposed tax legislation will be either neutral or positive for the municipal bond market.

Summing Up

The municipal bond market has seen increased volatility due to the rise in Treasury yields and the changing supply/demand dynamic of the market. There are many reasons to be optimistic that things will stabilize, but it is going to take some time to get a clearer understanding about the direction of inflation, Fed strategies, and Congressional tax policy plans. Liquidity has remained strong, the credit outlook is positive, and interest rates for new investments are a little higher. In our view, there are many reasons why municipal bonds remain attractive investments.

 

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies. 

 

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

 

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

 

Market forecasts and projections are based on current market conditions and are subject to change without notice.

Projections should not be considered a guarantee.

 

Fixed-Income Investing Risks

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price.

 

The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

 

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

 

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

 

The views and opinions expressed are as of the date of publication and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

 

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

 

Please consult your investment professional for additional information concerning your specific situation.

 

Glossary & Index Definitions

 

Advance refunding refers to the practice of taking the funds received from a new bond issuance to pay off a prior issue's debt. This can only occur after 90 days have passed. Municipalities typically use advance refunding to lower borrowing costs and to take advantage of lower interest rates.

 

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point

 

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.

 

The Bloomberg Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term, tax-exempt bond market. Bonds must be rated investment grade (Baa3/BBB- or higher) by at least two ratings agencies.

 

The Bloomberg High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.

 

Bloomberg Index Information:

 

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material or guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, shall not have any liability or responsibility for injury or damages arising in connection therewith.

 

 

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

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