Top of the Morning: Muni Market update - Flows gather momentum
The desk sees opportunities arising in the municipal bond market as recent inflows and performance trends suggest favorable conditions going forward. Per the full note from UBS, September marked a strong rally for investment-grade munis that persisted into October, contrary to typical seasonal trends. With investment-grade munis underperforming year-to-date and taxable munis demonstrating strength, notable discrepancies are creating pockets of opportunity. Although the macro environment is complex, the overall sentiment reflects a cautious optimism towards munis as inflows gather momentum.
What the desk is arguing
The desk frames this as a pivotal moment for the municipal bond market, noting that recent inflows and an unexpected performance rally open the door to investment opportunities. Specifically, Per the full note from UBS, both investment-grade and high-yield munis have experienced strong inflows despite underperforming on a year-to-date basis, with a particular spotlight on September's unusual strength.
The data supports this view: investment-grade munis showed a rally in September, even as they lag behind year-to-date metrics. High-yield munis have also tightened, suggesting readiness for a potential rebound, which could further enhance overall market performance. Taxable munis have particularly stood out, benefiting from their longer duration and falling Treasury yields, underscoring a significant opportunity.
Where it sits in our coverage
Current consensus targets across firms suggest a range for munis, with jpmorgan positioning comfortably at 1.10 for March 2026, while bofa holds a more cautious stance at 1.04. This view paints a landscape where there is favorable alignment for investment-grade municipal bonds.
The desk's perspective is more optimistic compared to bofa's lower target, indicating confidence in the potential for recovery in the months ahead, which might align with a broader recovery sentiment in fixed income markets.
How other firms see it
Several firms are aligned with this optimistic outlook for the munis space, including jpmorgan, reinforcing the strong recovery narrative. Conversely, bofa presents a more tempered view, projecting a cautious stance that may not capture the full recovery potential seen by others.
Traders would do well to watch the performance of investment-grade munis, as their trajectory could reflect broader economic sentiments. Key indicators like Treasury yields will also provide insights into risk profiles in this segment.
What the calendar says
No significant calendar events are slated that might impact this sentiment in the immediate future, allowing investors to focus on emerging trends within the muni market.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Municipal bond inflows have strengthened, defying typical seasonal trends.
- 02Investment-grade munis are expected to recover despite year-to-date underperformance.
- 03Taxable munis are currently outperforming due to their longer duration and yield dynamics.
- 04Overall sentiment in munis is cautiously optimistic as strong inflows indicate potential opportunities.
Market implications
Watch the performance of investment-grade munis closely; a breakout above recent resistance levels could trigger increased buying. Concurrently, any shifts in Treasury yields could influence rates and affect positioning ahead of broader market moves.
Risks to this view
Should economic indicators release weaker than expected results or should there be a significant pivot in monetary policy towards tightening, it might reverse sentiment and lead to underperformance in the muni sector. This would be notably significant given the current inflow trends and recovery outlook.
Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.
For today, we will revisit the muni market, spend some time highlighting the recent municipal market guide from the UBS Chief Investment Office. A title there is Flows Gather Momentum. Joining us, a couple of contributors to that report for today's conversation.
Glad to welcome back from the municipal research team within CIO, both Sudeep Murkherjee as well as Janine Lennon joining us for today's update. So with that, Sudeep, Janine, thank you both for dropping by today, spending some time with our listeners, our clients. Sudeep, let me pass it over to you to kick things off.
Welcome back. Thank you, Dan, and there's just a lot to unpack within munis. So let's get right into it.
So let me just first start with a broad performance recap. Investment-grade munis enjoyed a really strong rally in September, continuing into October, kind of defying historical trends as these two months have generally not been very supportive of total return performance. So that was certainly good news.
High-yield munis also outperformed in September, stretched their remain tight, and a little bit on that a little later in the conversation. But however, both investment-grade munis and high-yield munis are underperforming year-to-date, and especially with regard to investment-grade munis, that is a pointer that opportunities are continuing in our space. In contrast, though, year-to-date taxable munis have outperformed, really one of the best performers within U.S. fixed income, and that's really given their longer duration and the decline in treasury yields.
So overall, in the munis space, taxable munis are at the top of the stack there, whereas investment-grade munis, despite the rally, continue to underperform year-to-date, and therefore opportunities are persisting. Let me get to the macro environment. There's a lot of headlines there, but overall, to distill the macro environment in terms of munis, the impact of government shutdown and the U.S.-China trade tensions that go back and forth, the impact on the muni market has been relatively muted, so that's really a good thing.
Chair Powell laid the ground for October cut as downside risks to employment have risen, so CIO anticipates rate cut in October and December, followed by in the first half of 2026. So the easing cycle continues. That is certainly a tailwind and a supportive factor for fixed income and in general munis as well.
The other side of the coin, inflation does remain about the Fed's target. There is uncertainty there. We do expect inflation to rise.
We don't expect it to really go out of bound here, but there is some uncertainty there. Supreme Court outcome on tariffs remains quite uncertain, so the easing cycle will progress, notwithstanding that uncertainty in inflation in our view, but that does remain one of the risk factors here. The Denier Treasury now at around our year-end target, so we're not expecting significant impact from rates on the muni market till year-end, obviously for longer investment horizons, and we'll talk about that.
It's really about coupon income, not price dynamics, so the slope of the curve and the yield levels do matter for longer holding periods. Economic growth to slow in Q4, but remain close to trend growth in 2025, so not a big movement there in our view. Credit conditions are still benign overall, despite some headline news in regional banks and within munis, fundamental muni credit quality remains solid with some mixed rating actions in different sectors.
Overall, credit conditions remain pretty solid in muniland. Overall, with regards to the macro environment, it remains favorable for munis till year-end, but focusing now on the investment-grade tax-exempt market, which is our main focus, one of the key themes there, and one of the key themes is flows. As we pointed out in the report, flows have gathered momentum.
Net inflows into investment-grade munis in September were the largest in the last 12 months, with longer maturities receiving the largest share. So, as the year started and there was a sell-off in April, obviously money flew into a shorter duration, but since then, the longer hindrance has attracted capital, and that really accelerated, both in terms of level of flows as well as the share of the longer duration since about August, since September was especially a very, very strong month. Interesting thing there is ETFs continue to show strong momentum and attracting flows.
So, just to give you a sense, year-to-date, 35 billion has flown into munis on net basis, of which ETFs accounted for almost two-thirds. So, ETFs are still a small segment of the overall muni market, but growing pretty strongly there. The AAA tax-exempt curve has flattened recently.
Flattening has been kind of the theme in both the treasury market and the muni market, but in the muni market, most of that flattening has happened in the two-to-ten-year area. The 10-to-30-year slope still remains pretty steep, so making longer-dated bonds attractive. So, even after the rally, longer-maturity munis have actually risen year-to-date, even as longer-dated treasury yields have declined.
So, there's still a bit of disconnect in that long end. The front end of the curve, of the muni curve, especially the five-year area, now looks rich in terms of a lower MT ratio. So, with all that in mind, in our last report, we closed our preference with three-to-seven-year within our barbell strategy, and we now slowly prefer the seven-year-to-30-year on the curve.
Historically, a steep curve, as I mentioned, the difference, the 10-30-year slope on the muni curve is not just steep relative to its own history, but it is also very steep relative to its history vis-à-vis the treasury yield. So, on both those grounds, the longer-end steepness is an attractive feature for longer-maturity bonds. And historically, a steep curve has driven strong 12-month forward total returns for longer-dated bonds.
That said, obviously, longer duration carries extra interest rate risk, and this is really applicable for longer investment horizons. That is where these opportunities are more likely to unfold, even though September has been a very strong month in that regard. So, the other interesting thing about the market, I've said that September-October typically tends to be weaker performance, but pros supported the market rally even as technicals weakened.
And technicals weakened, by technicals, I mean the balance between demand and supply. Supply rose and redemption demand fell. So, technicals, the net supply has risen.
Till year-end, we actually expect supply to ease and we expect stronger demand. So, technicals should improve from here in November and December. So, overall, a fairly constructive view here with yields still attractive, the slope still steep, credit conditions fairly benign, and technicals set to improve till year-end as the easing cycle progresses.
Let me now come to some specific themes in the market where we see opportunity. Firstly, investors not subject to AMT should consider AMT bonds given their attractive spread over non-AMT bonds. Airports, local governments, higher education and high-quality hospital bonds look attractive to us.
That last segment is certainly for people with investors with a higher risk tolerance, but those are the sectors where we see value till year-end. And also, we demand investors that as they approach year-end, they could consider opportunities for tax loss harvesting through tax loss swaps. This is really a tax deferral strategy where investors sell munis currently trading below their cost basis and that capital loss can offset capital gains in other parts of their portfolio.
So, useful thing to consider. We note that UBS Financial Services does not offer or provide any tax advice. So, investors should consult their own tax advisor prior to investing in any such strategies.
Let's talk about credit quality a little bit here. Credit quality has not played a differentiating role in the muni market in terms of year-to-date total returns. So, credit has not been a big factor this year.
It's really been all about the duration, treasury bond deals and supply. But BBB spreads are still relatively tight. They have widened recently, but they're still relatively tight and look at longer-to-run averages.
So, we don't really see a lot of risk-reward value going down the spectrum. So, we have continued to prefer higher-quality bonds, higher-rated larger issuers is where our focus is. All of that said, fundamental credit quality, as I said in the beginning of the conversation, that remains pretty strong.
Sector rating trends have been somewhat mixed. For example, states' housing and transportation have seen strong upgrade momentum, whereas healthcare and utilities have lagged, have seen increased rating pressures and downgrades. But overall, when you look at the total market, fundamental credit quality remains pretty solid.
And finally, we're talking about high-quality in sectors. In this month's edition, we wrote about states in our spotlight section. And states are perhaps single most important sector in MUNI.
Single most important by what I mean is they touch a lot of other sectors. They have a lot of impact in the market. They directly and indirectly impact many of the other municipal sectors.
So, the credit health of the overall health of the MUNI market is fairly critically dependent on the health of states. But to talk more about states and share our views on that important sector, I want to invite my colleague Janine Denon into the conversation. So, Janine, could you take us through the key highlights as to what you're seeing in states, how are states positioned from a credit perspective?
Certainly. Thanks, Sudeep. And good morning, everyone.
As you mentioned, it was featured in this month's spotlight. The state sector has seen its fair share of volatility, proving resilient amid financial, economic, and political challenges over the last five years. The spotlight was notably highlighted following this year's annual review of the state sector as part of our team's CIO Municipal Risk Frameworks, which was published on October 1st, titled States Slow and Steady.
Following the annual review, 49 of the 51 states, including D.C., received CIO Risk Categories 1 and 2, reflecting low overall risk supported by their broad budgetary flexibility, diverse economies, substantial fiscal reserves, and experienced management teams. These strengths enable states to manage policy uncertainty and potential economic slowdowns, helping them maintain balanced budgets to meet their debt obligations. It is also these intrinsic credit fundamentals which ultimately support our stable outlook for the sector, despite the increased noise and headlines.
As some background for our listeners, our annual sector reviews typically take between four to six weeks to complete, with the state's framework beginning in August. At that time, the report considered the impacts of federal policy actions taken to date, including the passage of the One Big Beautiful Bill, would seek significant modifications to Medicaid and SNAP, among others, in addition to the federal government's desire to restructure FEMA, all of which will likely result in increases to state funding responsibilities over time. Notably, no two states are the same in terms of its revenue generation or its spending priorities, so the impact of these changes will vary by state depending on the fiscal strategies that they employ, their location, i.e., their susceptibility to extreme weather events, and their economic profiles, for example.
Now, just because we think our CRO risk categories will remain stable over the next year does not necessarily mean that there won't be an uptick in headlines and credit pressure in the face of continued policy uncertainty. Look no further than the date on which we published our state report, for example, October 1st, when the federal government shutdown began. The closure and the passage of the One Big Beautiful Bill matters for states as they receive a significant portion of their revenues from federal transfers, so reductions in federal support or shifts in policy can pressure state budgets and create various types of operational strains.
As such, the federal government shutdown has introduced varying degrees of operational and fiscal pressures, but looking ahead, we will monitor its duration and evaluate its impact on states, but want to reiterate that we expect proactive management teams will respond responsibly and timely with their broad powers to offset the ongoing financial, economic, and or political challenges over time. Thank you, Janine, that was an excellent comprehensive comments on states and good to know there about their resilience despite the ongoing policy uncertainties. So, in summary, I would say that we continue to hold a very constructive view on the money market, you know, rate cuts, momentum and flows, still elevated yields, a steep curve, and resident credit quality are all fairly supportive factors still till the year end.
So, with that, let me hand it back to you, Dan. Well, Sadiq, Janine, thank you both for dropping by top of the morning, keeping our listeners, our clients, informed on CIOs thinking when it comes to the municipal bond market. Again, I want to point you, our listeners, our clients, to the publication which Sadiq and Janine have been making reference to on today's episode.
Again, that's the latest municipal market guide. Title is Flows Gather Momentum, is available for you now up on UBS.com forward slash CIO. Though for clients of UBS, simply reach out to your UBS financial advisor if you would like to receive a direct copy of the municipal market guide.
Again, today we've been joined by Sadiq Markerji as well as Janine Lennon from the municipal research team at the UBS chief investment office. From UBS studios, I'm Dan Cassidy. Thank you for joining us.
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