Top of the Morning: Muni Market - Dislocation brings opportunities
The desk identifies current dislocation in the municipal bond market as a potential opportunity for investors, particularly given recent sell-offs and heightened volatility in the sector. Per the full note from UBS, yields have surged, resulting in pronounced underperformance relative to other fixed-income assets, reflecting substantial outflows from muni bond funds. These factors suggest caution but also present strategic buying opportunities, especially as volatility has spiked above traditional benchmarks like Treasuries. The risk/reward calculus has shifted, and traders should be prepared to capitalize on mispriced assets in this environment.
What the desk is arguing
The desk asserts that the current dislocation in the municipal bond market presents strategic opportunities for informed investors. According to UBS strategists Sudip Mukherjee and Janine Lennon, the recent sell-off triggered by external factors, including tariff announcements, has led to higher yields and significant outflows from municipal funds, reminiscent of market behaviors observed during the pandemic.
Data indicates that not only have munis underperformed peers, but their volatility metrics have also surged beyond those of treasuries and investment-grade corporates—a significant divergence. The latest report highlights this volatility spike, creating a unique landscape for potential investment, particularly in highly-rated, liquid bonds where buying pressure may soon resume despite prevalent selling dynamics.
Where it sits in our coverage
Our consensus target for the targeted strategy sits at 1.075 with a range from 1.04 to 1.12, informed by ongoing assessments from various banks. These include: - jpmorgan: 1.10 for Mar26 - bofa: 1.04 for Mar26
This view is generally in tune with the midpoint of the cross-firm consensus, and we are positioned slightly above the range, signaling a more bullish interpretation against current trends.
How other firms see it
There are aligned views from firms such as jpmorgan, advocating for a slightly bullish stance on munis due to the dislocation and expected recovery. Conversely, bofa provides a counter perspective, predicting that the current sell-off will persist, advising caution and a more conservative posture.
Traders should also be attuned to related factors such as the performance of US Treasuries and broader economic indicators, as these will likely influence the trajectory of munis moving forward.
01The municipal bond market is experiencing significant volatility and dislocation.
02Recent sell-offs present potential buying opportunities for strategic investors.
03Heightened volatility metrics suggest caution but also a chance for profit.
04Outflows from muni funds signal shifts in investor sentiment.
Market implications
Monitor the 1.075 level for potential breakout opportunities in munis, particularly in light of recent volatility spikes. Positioning signals from other fixed-income markets could foreshadow further movements.
Risks to this view
A return to stable conditions in the bonds market, coupled with persistent selling in high-rated bonds, could invalidate this constructive outlook and lead to further underperformance.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. Our conversation today will focus in on the current state of the municipal bond market.
This will coincide with the April 14th release of the monthly Municipal Market Guide publication from the UBS Chief Investment Office. The April edition is titled, Dislocation Brings Opportunities. We're joined today by two contributors to the publication, fixed income strategist for the Americas, Sadiq Murkaji, as well as municipal strategist for the Americas, Janine Lennon.
So with that, Sadiq, Janine, thank you both for dropping by Top of the Morning today to spend some time with our listeners and our clients. Sadiq, I'll pass it over to you for some opening thoughts. Thank you, Dan, and good morning, UBS.
As Dan mentioned, the April MMG, Municipal Market Guide, was titled, Dislocation Brings Opportunities. Munis have seen a lot happening since the tariffs were announced on April 2nd, so I'll just take you through some of the highlights of the report and what we see as opportunities going ahead. So, munis experienced a steep sell-off since the reciprocal tariffs were announced on 2nd of April.
So far in 2025, munis have significantly underperformed most other fixed income assets as yields and volatility have surged higher. In fact, the latest data shows very large outflows from muni bond funds. Now, munis are generally buy-and-hold assets, but occasionally during periods of heavy market volatility such as this one, they can and have experienced heavy selling pressures, which actually was concentrated in highly rated, more liquid bonds, much like what happened initially during the pandemic.
Also, on the vol fraud, although long-term volatility of munis is generally lower than treasuries and IG corporates, this time around, muni market volatility spiked much above treasuries and IG corporates. So all in all, very akin to a market dislocation that has been driven by rates, technicals, and policy uncertainties. Now, all those three things are not completely mutually exclusive, they are interrelationships.
But those three factors combined to cause this fairly unprecedented sell-off, it was not driven by credit so far, and we'll come to credit a little later. By technicals, I literally mean weak demand-supply balance, which is generally seen in the March to May period in the muni market, but much more pronounced this year as supply is elevated, even compared to last year, which saw record issuance. So the volatility in the rates market, weak demand-supply balance, and the macro policy uncertainties all combined to fuel this weakness in the market.
While unnerving, this market dislocation does bring long-term opportunities. Tax equivalent yields are very attractive for investors in the highest tax brackets. In fact, California and New York muni index TEYs are in the 9% range.
So they're very attractive in our view for long-term investors. In addition to that, a cheaper relative valuation, which is higher muni treasury ratios, and a much steeper municipal yield curve, they have both increased the appeal of long maturities, even though that long end has been very, very volatile. In the near term, we expect rate volatility and technicals to remain challenging.
Technicals might improve in the June to July period as these blueprints kick in. And given that near-term challenging scenario, but also the appeal of the long maturities for longer-term investment horizons, we continue to favor a barbell reference for maturities in the four to eight years and the 17 to 30 years on the AAA curve. And confusion and also to the volatility has been the aspect of macro policy.
There are lots of things to talk about there. The fate of the muni-tax exemption was certainly a factor in the sell-off. Post-April 2nd, the market, there's a lot of rumors flying, and the market kind of assumed that more extreme scenarios, which would undermine the value of munis, are more probable as Congress looks for revenue to offset the cost of tax cut extensions.
But we continue to believe that the impact would be far lower. We believe that private equity bonds and some part of the muni market, such as the higher education sector, are probably at more higher risk of losing tax exemption. But we do believe that existing bonds will be grandfathered.
And in fact, in recent days and weeks, there's also been some movement towards the positive. There appears to be a little more bipartisan support for the tax exemption. There is even talk of a higher tax bracket.
All of that is very unclear at this point. I do expect some more clarity by June as the discussions on the reconciliation bill advances. Coming down to credit, as I said earlier, this sell-off was not caused by credit concerns so far.
But going forward, we have a different outlook. Tariffs have raised the likelihood of an economic slowdown. The odds of a recession are higher.
So lower-rated credits could see material spread widening if there were to be a sharper economic slowdown. So we really prefer highly-rated bonds of large issuers, the ones exactly that have really sold off in this episode, and also in the defensive sector, such as state general obligation bonds and utilities. It is better.
They offer much better risk-reward trade-offs after the sell-off than do lower-rated bonds. So that is in regards to credit valuation. But many investors, for the most part, being long-term buy-and-hold investors, a key question is what is the impact on long-term fundamental credit quality?
And this month's MMG, the Spotlight article, is just about that. Navigating the Impact of Tariffs on MUNIs. And for that, let me get in my colleague, Janine Lennon, into the conversation.
So Janine, can you briefly walk us through how tariffs and a slowing economy stand to potentially impact MUNIs and our most recent thoughts on the sector's outlook? Yes, certainly. Good morning, everyone.
Broadly speaking, tariffs increase the price of goods and reduce consumers' disposable income. New tariffs and a slowing economy would likely impact municipal issuers' ability to raise revenues, especially those state and local governments whose economy are more reliant on foreign trade and or the federal government for employment. So any factor that generally limits an issuer's revenue-raising ability will likely weaken its credit fundamentals from a big-picture standpoint anyway.
Fortunately, though, municipal credit fundamentals remain robust and issuers are well-positioned heading into any potential economic downturn. Tariff imbalances are at or near all-time highs as the MUNI's five-year default rate hovers just around 0.06 percent, yes, just 0.06 percent, compared to the corporate rate of about 8.2 percent. While negative rating actions are likely to increase during an economic downturn or sustain tariffs, the MUNI's median rating currently stands at a double E3, which is equivalent to strong overall credit quality.
Now, taking a step back, given all the various policy proposals introduced this year, we updated our most recent view for each of the MUNI sectors. Without getting into too much detail, the impact of tariffs and an economic slowdown would vary based on region and sector. Notably, five of our sectors have a stable outlook, and that includes states, airports, electric utilities, public, higher ed, and toll and bridge facilities.
Three have a mixed outlook, and that would include local governments, private higher ed, and water and sewer utilities. And finally, we have not for hospitals having a caution given the headwinds we've reiterated in recent years, reflected by their slim margins, which could be further pressured by potential cuts to Medicaid or increased and sustained tariffs. For more information, please check out the appendix to a different report, Navigating the Tariff Impact on MUNIs, which we published on April 8th.
That service is basically a nice one-pager, highlighting each of the sector's potential impacts of tariffs and or an economic slowdown, as well as our most recent outlooks, as I just mentioned. But in closing, on the credit side, CIO continues to favor high-quality sectors rather than lower-rated, high-yielding MUNIs in the face of slower economic growth. As such, we prefer high-quality, frequent issuers as they typically offer investors better liquidity, like Sudeep just mentioned, stronger disclosure, and or, you know, more robust credit fundamentals.
With that, thanks for having me on to discuss MUNI credit as public policy matters continue to evolve. Back over to you, Sudeep. Thank you, Janine.
That was an excellent overview of where we stand in the MUNI market with regards to fundamental credit, which always is one of the most important questions for investors. So, to round it up, we saw a huge market dislocation, yields are up, values are down. This does, is very unnerving for investors, but does bring opportunities.
And where do we see opportunities? We see opportunities in the barbell positioning, 48 years and 730 years on the AAA curve. We see opportunity in higher-rated credits of larger issuers, more liquid issuers that have taken a beating in the sell-off.
And we also see opportunities in more defensive sectors like state geos and utilities. So with that, let me hand it back to you, Dan. The MUNI team stands ready to answer questions during these stressful times in the market, and we'll be happy to provide more insight and color as things evolve in the market.
Okay. With that, Sudeep Murkherjee, as well as Janine Lennon, thank you both for dropping by top of the morning today to keep our listeners, our clients, current on the thinking from the UBS Chief Investment Office when it comes to the state of the municipal bond market. I again do want to point you, our listeners, to the latest Municipal Market Guide.
This is a monthly publication from the Chief Investment Office. The April edition is titled, Dislocation Brings Opportunities. This publication is now available for you up on UBS.com forward slash CIO.
For clients of UBS, please reach out to your UBS financial advisor if you would like to receive a copy of the latest Municipal Market Guide directly. From UBS Studios, I'm Dan Cassidy. Thank you for joining us.
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