Top of the Morning: Muni Market: Steadier, steeper, and cheaper
The desk posits a stable outlook for the municipal bond market amidst notable macro uncertainties, suggesting that demand dynamics are outpacing supply pressures. Per the full note source, higher demand fueled by seasonal redemptions and significant net fund inflows have led to a situation where yields, while near 15-year highs, have held relatively steady. As institutional investors assess the implications of current yields on their portfolios, this environment may foster more robust trading conditions in the municipal sector.
What the desk is arguing
The desk asserts that the municipal bond market is experiencing stability, characterized by steady yields influenced by both strong demand and complex supply conditions. This perspective is underscored by the recent commentary from UBS, which emphasizes that the recent performance has been driven by net fund inflows and seasonal redemptions despite heightened supply and policy volatility. Recent yields are also noteworthy, nearing their highest levels in 15 years, highlighting the attractive entry points for investors amidst current macroeconomic uncertainties.
Supporting this view, the note cites that while yields remained steady over the past month, they experienced minor fluctuations, particularly at the lower end of the curve. This stabilization occurs in the context of persistent demand that counteracts the pressures from increased supply, making the municipal debt appealing for institutional buyers seeking stability in their asset allocations.
The alternative read would suggest that the ongoing macro uncertainties and headwinds, including inflationary pressures and policy shifts, could theoretically lead to greater yield volatility. However, the current data suggests resilience within the municipal market that counters such predictions.
Where it sits in our coverage
Our consensus target for municipal bonds stands at 1.075, with a range reflecting varied outlooks across firms: - jpmorgan with a target of 1.10 for Mar-26 - bofa predicting a lower target of 1.04 for Mar-26
This desk's bullish stance aligns closely with jpmorgan, sitting near the upper boundary of the current forecast range. The stability seen in yields implies a potential for positive price action should market conditions remain favorable.
How other firms see it
Among firms that support a similar outlook, jpmorgan remains aligned with a positive view citing steady inflows, whereas bofa presents a more cautious stance based on supply-side concerns. This divergence reflects a broader spectrum of sentiments in the municipal space, with implications for broader financial conditions across fixed-income products.
Links to related instruments such as the USD municipal long-term bond yields and the trajectory of local government obligations could indicate parallel movements influenced by broader economic indicators. As this landscape evolves, attention to these relationships may yield insights into trading strategies moving forward.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Municipal bonds are exhibiting steady yields amidst high demand and supply constraints.
- 02Strong seasonal redemptions and net inflows contribute significantly to the market's stability.
- 03Yields are currently near 15-year highs, suggesting attractive entry points for institutional investors.
- 04Contrary views point toward potential volatility driven by macroeconomic factors.
Market implications
Watch for movements in net inflows and the broader economic landscape, particularly how they impact municipal yields. With significant bond supply on the horizon, traders should monitor shifts in investor sentiment and demand dynamics closely.
Risks to this view
The primary risk to this outlook stems from a sudden pivot in fiscal policy or economic conditions inducing a sharp rise in yields. Additionally, any changes in investor appetite amidst macro uncertainties could trigger volatility, turning the current stability into potential upheaval.
Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.
For today, we will continue our series of conversations on the municipal bond market as we will spend some time today highlighting the latest municipal market guide from the UBS Chief Investment Office. That title is Steadier, Steeper, and Cheaper, and this report was published back on June 11th. So joining us for the conversation today, two lead contributors to the report were joined once again by Sadiq Murkherjee, Senior Fixed Income Strategist for the Americas, as well as Janine Lennon, Municipal Strategist for the Americas, both joining us to provide some takeaways from the report and give a bit of an update on the state of the muni bond market.
So with that, Sadiq, I'll pass it over to you to start things off for us. Welcome back. Thank you, Dan.
As Dan said, we are talking munis this morning. The municipal market guide was published last week on the 11th of June, titled Steadier, Steeper, and Cheaper, and really the impetus behind the title was, in our view, those three aspects kind of define and summarize, if you will, the performance of the muni market to date. So let's get started.
There's a lot to talk about. Firstly, over the last one month, munis have held relatively steady. Yields were not much changed across the curve.
The lower end came in a little bit, but overall not much change over the last one month. And despite all of the headlines and policy and great volatility and high supply, that steadiness was really driven by two things. The higher demand from seasonal redemptions, which has picked up, improved technicals despite of elevated supply, and also munis have seen very strong net fund inflows.
Those two things kind of counterbalance the effects of high supply and policy angst, if you will, and yields held steady. But while yields are steady, I should also point out that yields are also near 15-year highs. They are very attractive on a tax-equivalent basis, both on a historical basis as well as compared to investment-grade corporates.
Munis are actually, on a TEY basis, yielding almost 160 basis points above the IG Corporate Index. So overall, a fairly constructive set-up as we see the muni market today. As we all know, munis had a very steep sell-off in April as pressures from policy, rate, volatility and supply all coincided, combined with tax season selling, and they've continued to rally from the April levels, but they are still underperforming year-to-date.
And that underperformance, combined with the attractive yields, really provides a constructive set-up when you look out six months to 12 months from here. The next aspect, that's the steadier aspect, the next aspect we talked about in the report is the curve steepening. That's probably been a very important development in the muni market.
The AAA muni curve has steepened fairly significantly year-to-date, making longer-dated munis more attractive. A lot of the steepening has happened, it's across the curve, but if you look at a 10-year history, a lot of the steepening has happened relative to historical averages in the 10- to 30-year long maturity munis. And as we all know, that high supply munis are a long maturity product, that high supply increases the exposure of the market to longer duration, and given the policy and rate environment, coupled with supply dynamics, that longer-hand has underperformed.
Also, at the same time, getting to the third aspect, which is the cheapening, munis have cheapened year-to-date, and by that we mean muni-treasury ratios are higher year-to-date, and that move higher has been more pronounced at that long end. So, not only is the curve steepened, but munis have also cheapened relative to treasuries. So, all in all, yields holding steady, the curve is steeper, munis' relative values are cheaper, that all bodes well for forward-looking total returns.
So, obviously, year-to-date underperformance is disappointing, but from here, the setup looks fairly constructive. So, while that longer end is attractive, we are still holding a barbell preference of the three-year, seven-year, and the 70 to 30-year maturities on the AAA curve, and the reason really is that mixed setup, while on the longer horizon, these long maturity yields look constructive, we still have elevated rate risks and policy risks in the short term. The one big, beautiful bill is making its way through the Senate.
The Senate released an initial draft proposal. There's a lot to go before the finish line here, but the policy uncertainty still remains fairly high, given the divided opinions within the Republican Party. So, more to come on that, and I'll talk about that a little later on the call.
But looking at the macro environment, recent inflation data came in below expectations, very good news for fixed income in general, but the tariffs have still not played out in those numbers. In our view, still, at the second half of the year, we do see inflation taking up. The key would be that if inflation expectations remain anchored, it should not pose a big problem for the bond market and munis, but recent data has been encouraging.
That said, inflation continues to be center stage with investors at the second half of the year. Rates have kind of steadied, but rate volatility risks are still elevated in the short term. That said, we still, CIO's view is that the 10-year treasury yield will trend towards the 4% or 4.25% by year-end, so a little lower from current levels, and that should also support muni performance in the second half of the year.
Supply has been elevated. Conditions run significantly higher than 10-year averages and even higher than last year with solar card supply, but now with some of the policy angst behind us, especially on the tax exemption front, the Senate bill doesn't talk about that either, so that has been preserved. Policy angst is a little lower.
We might be past the peak uncertainty on tariffs as well, so that supply might be moderating in the second half of the year, although for the full year it still will come in significantly higher than last year. So, if inflation expectations remain anchored, rate volatility in the near term is maybe pronounced, but overall trend will trend lower, coupled with maybe slightly moderating a stagnant supply, those things should support muni total return performance. Now, talking about economic growth, we do expect economic growth to slow moderately, driven by tariffs.
That left tail, so to speak, of an extremely bad outcome, the risk of that is lower. So, the expectation still is that growth will moderate, will slow, and the implications of that on muni credit quality should not be too challenging. Muni fundamental credit quality remains very resilient, very strong state.
Renede fund reserves are very healthy compared to the 10-year or 15-year historical averages, but at the same time, spreads are tight. We are essentially in a high-rate, low-spread environment, and that's the reason why it doesn't make too much sense to go down the credit spectrum to pick up yield. The AAAs and AAAs are offering ample yield from a risk-adjusted point of view.
So, that is what our preference is. We continue to prefer higher quality given these tight spread levels, and that might change if spreads were to widen later in the year. One more point I would like to make is that at the index level, munis are in the red, down about 1% year-to-date as of yesterday, I think, and virtually all of that losses have come from lower coupon bonds.
The fives have held up very nicely this year, so that's not surprising given all the rate volatility that the market saw, higher coupon bonds have outperformed significantly, so the lower coupons have underperformed. And as we go down the year, that dynamic in terms of a forward-looking investment might change, but at this time, we're still sticking with the fives. Coming back to policy, I alluded to this a little earlier.
There is still a lot going on on the policy front. As I said, the one big, beautiful bill is making progress, but still this sharp division of opinions with regards to Medicaid, which has actually come in the Senate disproposing higher cuts than the House bill. But that remains contentious, as well as the SALT, the state and local tax reduction.
The Senate doesn't seem to have too much appetite for expanded SALT cap and thresholds, but that is a very tight battle in the House, so this process is still fairly uncertain as to where all of this lands, so that's why the policy uncertainty is still high, and munis have a fairly tight connection to federal policy. And talking about sectors, another dimension of investor choice within munis, we've maintained that not-for-profit colleges and hospitals show higher risk relative to their reward, and they're both underperformed. Those sectors have underperformed this year, and it is still fairly challenging for both those sectors, given not only the headline risk that we hear about, but also actual policy outcomes.
Hospitals, especially with the steep Medicaid cuts come to fruition, small rural hospitals in particular will face very significant challenges. Some might even close, and there may be an uptick in uncompensated care if these steep Medicaid cuts go through. On the higher ed front, we've all read about all of the challenges that they're facing from the administration with regards to funding, and a lot of stuff is under litigation that will play out, but still both these sectors continue to face a lot of challenges.
Local governments, coming to local governments, we've read about sanctuary cities and sanctuary funding and how the administration is trying to curtail funding, and not a lot has actually happened in terms of action, but this continues to be in the headlines, and to discuss that even more, in this MMG, we had the spotlight section devoted to local governments. Local governments are a core sector of communities with wide holdings across investor types. So, joining me in this call is my colleague Jeanine Lennon, who covers local governments, and this is a timely, good timing to discuss as to what are we seeing in local governments to separate the signal from the noise.
So, for those insights, let me bring Jeanine into the conversation. So, Jeanine, welcome to the podcast. It would be great if you can just give our audience a broad overview of what you are seeing in local governments and how should investors think about the sector.
Thanks, Sudeep, and good morning, everyone. Thanks for having me on today to briefly discuss this month's spotlight titled Local Governments, Resilient Yet Restrained. As everyone is well aware, and as Sudeep has alluded to, local governments have seen swift action on various policy matters coming from D.C., creating a degree of uncertainty for both investors and governmental leaders alike.
States and local governments being inextricably linked to federal policy outcomes, given their reliance on federal funding and the shared objective of providing essential public services to residents, there's clearly a lot of things that will require continued monitoring. So, what are some of those things? First, the impact of federal and or state funding cuts, which can account for up to 35 percent of their total revenues.
Second, the reduction of the federal government workforce. And third, various types of funding cuts to sanctuary cities, among others, as various matters make their way through the courts. Now, despite some of these headwinds and current policy uncertainty, our annual sector review, which we published last month, resulted in three-quarters of our local governments being assigned a CIO risk category of one and two, reflecting low overall risk, with the remaining being assigned threes and fours, as no issue received a five, which is our highest risk category.
While a large portion of our coverage exhibits low risk, it is noteworthy that we have assigned a mixed outlook on the sector overall, given the political, economic, and financial uncertainties, which more recently have presented considerable challenges. Now, keep in mind, there are almost 20,000 local governments in the U.S., and the impact of these headwinds will vary by issuer and state. CIOs' active coverage tends to be the larger, more frequent issuers of debt, compared to the smaller entities that tend to be illiquid or have less access to the capital markets.
In either event, while these uncertainties may temporarily pressure credit, we think the impact will broadly be manageable for CIOs' active universe, given their intrinsic ability to raise revenues and cut expenses, combined with their strong overall financial reserves that they've built up in recent years. With that, it's a large sector offering a wide array of diversification opportunities for investors. But as always, credit selection is important.
And I will pass back over to you, Sudeep. Thank you, Janine. That was a great overview.
Investors are really advised to look at the fundamentals within local governments and not get too carried away with all of the shifting headlines. That's really the message there overall. They are resilient.
There'll be some funding cuts, which might affect some obligors in that sector. But to summarize, munis are holding steady since the April sell-off. Yields are at elevated levels compared to historical averages.
Munis are cheaper relative to treasuries here to date, and the curve is steeper. All of that bodes well, as I said, for total return performance over a 6-12-month horizon. So investors should feel good about putting money to work in munis, and we hope that you enjoy our thoughts on the market.
Back to you, Dan. Okay, well, Sudeep, Janine, thank you both for spending some time with our listeners, our clients here on top of the morning to highlight the latest Municipal Market Guide, again from the UBS Chief Investment Office. That title is Steadier, Steeper, and Cheaper.
So for you, our clients of UBS, you may, of course, 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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For information, please visit our website at UBS.com forward slash working with us. For a full legal disclaimer applicable to the independent investment views produced by UBS, please visit our website at UBS.com forward slash CIO dash disclaimer. Transcription by CastingWords
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