Municipals Thoughts from the Municipal Bond Desk

Tim: As expected, the Federal Open Market Committee (FOMC) unanimously voted to raise interest rates at the September Federal Reserve (Fed) policy meeting.

Mark: Right, for the first time in a while, all FOMC members were on the same page. All 18 members voted for the 25-basis-point hike, which was the first increase since 2023.¹ So why now? Fed Chair Kevin Warsh put it bluntly at the press conference: “The plain fact is inflation is too high and has been for too long.” He framed the move as a way to “support a timelier return” to the Fed’s 2% inflation target. The Fed also flagged that "uncertainty remains elevated, owing, in part, to geopolitical developments.” And this probably isn't a one-and-done scenario. Sixteen of the 18 FOMC members penciled in at least one more hike before year-end, and a few see more coming in 2027. At this point, I don’t believe this means the Fed has begun another tightening cycle. Rather, it seems to be an effort to stem further inflationary pressure from higher energy costs. Warsh's promise was that the committee “will deliver price stability,”¹ which — along with maximum employment — is half of the Fed's dual mandate.

Tim: The muni market has exhibited significant volatility in recent months. What’s driving it?

Mark: Not municipal credit quality, in my opinion. The volatility seems to have been driven by interest rate moves in the US Treasury market, which munis tend to follow whether the underlying fundamentals justify it or not. The annualized daily standard deviation US Treasury Index returns stood at 4.38%, versus 3.36% for the Bloomberg Municipal Bond Index and 3.41% for the Bloomberg Municipal High Yield Bond Index, year to date as of September 21.² With daily volatility that’s roughly 1.3 times that of the two municipal indexes, I believe the data illustrates that the muni market has been the passenger, not the driver. As the rate picture settles, I'd expect muni volatility to settle with it. In the meantime, long-term investors have the potential to be nicely compensated to wait.

Tim: I think investors could find some attractive entry points into the muni market at the moment, especially if they’re looking for high-quality securities.

Mark: I agree, Tim. A few things have converged here: rising Treasury yields, heavy tax-exempt muni supply, limited reinvestment, and tax-related trading have pushed muni yields to unusually high levels. The taxable-equivalent yield on a 30-year AA muni bond for top tax-bracket joint filers reached 8.67% on September 10, which was better than any comparable monthly average going back to November 2000.³ That could definitely be considered a generational high. And historically, long-term high-quality munis yielding 5% or more have attracted considerable interest from investors, especially those in the highest income tax brackets.³ I’d expect that to happen again, although it may not occur until the final two months of the year. Muni issuance is still on track to be fairly heavy through the end of October, before moderating to lighter levels as redemption activity picks back up.³ Regardless, you don't get many chances to lock in tax-free income at these levels, and I don't think this window stays open indefinitely. For anyone waiting on the sidelines waiting for a better entry point, I would argue this might be it.

Read the complete article, including munis by the numbers.