Munis are not in lockstep with Treasuries, as supply plays a crucial role in how Munis react in a rising rate environment.
It’s Not All About the Fed, Munis Are Swayed by Weak Issuance
The Fed seems likely to raise rates again – what impact will that have on the muni market and yields?
The straightforward answer is that raising Fed rates will lower bond prices. The Fed has raised rates 11 times since March of 2022. We have gone from 25 basis points to 525 basis points, which is quite a difference. AAA muni yields increased from 1% in the 10-year space to 3%. From where we sit, we see investors rewarded with higher returns in a solid, high-grade market with the added attractive tax exemption benefit.
Yet, it hasn’t been “basis point for basis point” for munis in how we followed the Treasury market. While muni yields widened by about 200 basis points, we have been quite expensive compared to Treasuries on a ratio basis for some time. For example, 2/5yr ratios are well under the historical averages. In my opinion, one of the reasons explaining the richness of munis is the dwindling supply.
So far this year, new issuance is running about 21% lower compared to the same period in 2022. The issuers hit the pause button, initially expecting the pivot, and now expecting inflation to subside and, perhaps, yields to decline. Anecdotally, some of the projects that were online pre-COVID have been repriced now and are roughly 30% more expensive. So the issuers who paused because they thought the Fed would roll rates back – that’s not happening yet – are now waiting to see if the Fed’s aggressive tightening will overpower inflation – again, not happening yet.
The 21% decline in issuance is startling. But another surprising data point is that the overall size of the muni market hasn’t changed much in the past decade. We were around $4 trillion in 2013 and around $4 trillion in 2023. In contrast, the taxable bond market expanded by 46% in 10 years, while mortgage-backed securities grew 39% during the same period.
I am not arguing for abundant, some may say reckless, issuance by municipalities, but I am highlighting that supply plays a role in how the tax-exempt market reacts through a rising rate environment.
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