Municipals Thoughts from the Municipal Bond Desk

Tim: Municipal investors have seen sharp swings over the past two months, with September’s selloff giving way to a significant October rebound.

Mark: Yes, it’s been a wild ride. After bruising declines in September, the Bloomberg Municipal Bond Index staged a strong recovery during October, recording its strongest performance in three years and its best October performance since the Bloomberg Municipal Bond Index began tracking returns in 1980!¹ Investment grade tax-exempt bonds returned 3.85% in October, retracing much of their September’s losses.¹ The rally was driven by declining US Treasury yields, as investors sought perceived safe havens amid a drawdown in technology stocks and higher-than-expected inflation data. Supply-and-demand conditions reinforced the market’s momentum. New issuance moderated in October, with roughly $48 billion brought to market compared to the $55 billion issued in September.¹ At the same time, investor demand remained strong, allowing the market to digest the lighter supply. I think we are going to see a similar technical picture in November, with about $33 billion in new issuance due to a slowdown in refunding activity, the effects of the election cycle, and the holiday calendar.² Demand should be well supported by historically high tax-exempt yields. 

Tim: Speaking of demand, while flows have stayed positive, they have been focused on municipal ETFs.

Mark: Instead of on mutual funds, yes. It’s a notable divergence. Historically, mutual funds have received the lion’s share of investment inflows. However, looking at the week ended October 28, the municipal market saw a total of $1.7 billion of inflows, with $3.5 billion going into ETFs and $1.8 billion coming out of open-end mutual funds.² It was the eighth consecutive week with this kind of divergence.² The plausible explanation for this is that investors used their mutual fund holdings to engage in tax-loss harvesting following the September selloff. Then, in my view, they put their money back to work in municipals, choosing to reposition their portfolios using ETFs. If history is any guide, we may see that divergence reverse in January and February. In the tax-loss-harvesting seasons in 2022 and 2023, mutual funds saw outflows and ETFs saw inflows. The following January and February flow picture then reversed, with ETFs seeing outflows and mutual funds receiving inflows.² Regardless, this year’s overall inflows have helped to absorb record new issuance of $517 billion year to date October 28, which is 5% higher than the same period last year.³

Tim: What are your thoughts on how the midterm election results will affect munis?

Mark: Time will tell, Tim, but markets usually focus on fundamentals, not political parties. And one party’s control of congress does not indicate where markets will go. So, in my opinion, economic growth, inflation, Federal Reserve policy, and interest rates will have more of an impact on munis than this election outcome.

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