Monthly update
- The robust recovery in muni bonds finally lost steam in August.
- Issuance remains strong but rising uncertainty has tempered demand.
- A lack of clarity around fiscal aid will likely exacerbate near-term volatility.
Market overview
After a strong three-month recovery, the muni market took a breather in August, with the S&P Municipal Bond Index returning -0.24% for the month, but leaving year-to-date performance still strong at 3.16%. All-time low yields, uncertainty around additional fiscal support, rising interest rates, and less favorable supply-demand dynamics weighed on the market in August. Longer-dated bonds were particularly pressured toward month end as a shift in the Fed’s mandate spurred higher inflation expectations.
Issuance remained relatively high for the month of August at $41.3 billion. Supply continued to outpace reinvestment of income from coupons, calls and maturities, negating the net negative supply that typically occurs at this time of year. In the secondary market, bid-wanted activity increased over the month while dealer inventories hovering near multi-year lows signaled a weaker appetite for muni bonds among the broker community.
Investor flows into municipal bond funds remained net positive but waned in the later part of the month as valuations became stretched and fundamental concerns resurfaced after Congress broke for recess without agreeing on a stimulus bill. New issues were oversubscribed by a lower rate in August (4.0x) versus the year-to-date average (5.9x), dragged down by weakness in the last two weeks of the month (2.3x).
Outlook
We foresee increased volatility in the months ahead and anticipate that a less favorable supply and demand dynamic will likely act as a drag on the market in the near term. We believe that clarity around the size and scope of additional federal stimulus is necessary to alleviate uncertainty and ease investor concerns.
Strategy
We maintain a short duration stance (i.e., a below-neutral level of interest rate risk) in our municipal bond exposure given stretched valuations and the potential for increased volatility in the coming months. We continue to hold a bias for higher quality assets overall and continue to advocate careful security selection as the impact of the pandemic varies across market segments.
Peter Hayes
Head of Municipal Bonds
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