Munis’ August performance reliant on carry as alternatives shine

This article was written by Bloomberg Intelligence Strategist Eric Kazatsky and Bloomberg Intelligence Senior Associate Analyst Karen Altamirano. It appeared first on the Bloomberg Terminal. 

Municipal bonds’ performance was positive in July but failed to meet our expectations. Exempts’ 0.41% return still beat losses of 20 bps for the US Aggregate and 47 bps for the US Treasury indexes. Though we expect positive returns in August, munis will be challenged by the pull of higher-yielding, more liquid alternatives such as Treasuries and agencies.

Outlook for August hamstrung by juicier options

Muni returns in August could be 0.6%, which would be the fourth-highest for that month in the past 10 years. August 2022’s return was the lowest for the month in the past decade, with munis declining 2.19%. Of the potential 0.6%, 35 bps could come from the carry portion of the index, while the residual 25 bps might stem from price appreciation. While some muni areas look favorable from a ratio standpoint, there are still taxable options, such as US Treasuries and agencies, that are luring crossover buyers.

Negative net supply may increase in August as another cash-heavy period gets underway amid tepid supply. With most of the move higher in rates priced into Treasuries, we expect rate volatility as a whole to be more muted, creating a better backdrop for muni reinvestment flows.

Supply/demand imbalance likely to persist

Using data from DSET <GO>, we can break down the roughly $4 trillion municipal market and see which months have the heaviest primary issuance and, in turn, ongoing maturities. August ranks third-highest in issuance, with about $43 billion on average over the past 10 years. We expect muni supply to remain below average through the summer, its heaviest time of the year in terms of maturity dates.

Expressed as monthly cash flows, August has an estimated $48 billion coming back to investors, up from $44 billion that matured in July, and is historically one of the heaviest month for redemptions. If investors continue to seek taxable income in lieu of accepting less yield in exempt alternatives, August performance could be kept in check.

California and Texas lead in August maturities

California and Texas have the highest volumes of bonds coming due in August. California is heavily weighted in terms of market importance, given its negative net supply of $7 billion. New York has negative net supply of $1 billion. If market dynamics maintain the current pace, with sales lagging behind, California could perform better than expected.

The largest August maturities include $3.2 billion of bonds for the Port Authority of New York & New Jersey, and $1.9 billion for the State of Washington.

Whether Fed is done is up for debate

With the last hike set in motion, attention now turns forward, with the market and pundits trying to ascertain what the Federal Reserve’s next move might be. Based on market sentiment and expert surveys, all of the data points to rate cuts toward year-end. On the surface, the prospect of easing is good news for municipal bonds.

The relative lack of new issuance has been blamed on the rising rate environment. This is true to an extent, since many issuers are heeding their advisers and waiting out the Fed if they don’t have critical bonding needs. While exempt issuance is down about 20% from the same time last year, the hope is that a drop in rates can help cut into the 50% year-over-year deficit in taxable-muni sales.