The surge in benchmark yields amid high volatility continued to prompt investors to pull sizeable assets from municipal bond mutual funds in October. (UBS)

Tax-equivalent yields (TEYs) garner attention
Tax-exempt municipal bonds now provide better value vis-á-vis taxable alternatives all along the yield curve, on a tax-adjusted basis (Figure 1).

Performance update
Last month, volatility in the rates markets and a hawkish Fed continued to weigh on fixed income performance month, including munis. In October, tax-exempt municipal bonds posted a negative return (-0.9%), but at less magnitude than the steeper losses seen one month earlier (-3.7%).

By comparison, amid a rough year for an array of asset classes, munis (-13.3%) have held up better than their taxable investment grade corporate debt counterparts (-19.2%) on a year-to-date basis. We attribute the better performance from munis in large part to subdued new issuance, reflecting ongoing rate volatility.

Issuance remained light
In October, the volume of new municipal bond sales (USD 24.9bn) declined by 40% compared with the same time last year (USD 41.8bn). We attribute most of this decline to a sharp drop seen in taxable muni new issuance, reflecting high rate volatility. In the first 10 months of 2022, taxable issuance has fallen by 50% from levels seen one year earlier. By comparison, the pace of new tax-exempt municipal bond sales has declined but at a lesser magnitude (to USD 270.6bn from USD 292.2bn, -7.4% YoY).

Benchmark yields hit new year-to-date high
As a point of reference, since 1 January, the yield on the 10-year benchmark US government note climbed by almost 200bps to reach 3.47% in mid-June, before falling back to 2.57% in the early part of August. More recently, the 10-year government yield resumed its trend higher to hit a new year-to-date high in mid-October (4.24%), before reversing course to end the month at 4.05%. Meanwhile, high grade AAA muni yields at the 10-year maturity point climbed by another 9bps to sit at 3.39% at the end of last month.

Fund outflows continue
The surge in benchmark yields amid high volatility continued to prompt investors to pull sizeable assets from municipal bond mutual funds in October. On a year-to-date basis through the week ending 26 October, the Investment Company Institute had reported net cash outflows from muni funds totaling about USD 122bn. By contrast, the municipal exchange-traded fund sector has recorded net inflows through the first 10 months of the year (USD 20.2bn), but remains a relatively small portion of the buyer base. We attribute at least some of these inflows to tax loss selling activity by investors swapping open-end muni funds into exchange traded funds, allowing them to realize a loss while maintaining exposure to the tax-exempt sector.

Over the summer, credit quality spreads have been relatively stable, before inching a bit higher over the past two months. Since 1 September, spreads on BBB munis at the 10-year spot increased by 7bps to now rest at 96bps as an example.

Markets have already priced in a 75bps Fed rate hike this week. That said, we expect volatility to remain elevated through year-end. Until there is clear evidence that the Fed is poised to moderate the pace at which it tightens monetary policy, retail investors are likely to continue to park assets in cash and cash equivalents. However, the attractive income opportunities now available to investors provide a silver lining.

As a point of reference, yields on high grade 2-year to 5-year munis range from 3.25% to 3.35%, representing the highest levels seen in 15 years. At the same time, longer-dated AA high grade muni yields have climbed to now sit at levels (~4.5%) not seen in nine years. Against that backdrop, we believe that positioning in short-dated bonds (for liquidity and reinvestment opportunities) along with an allocation to longer-dated munis with high coupons (for incremental income) is prudent. Bear in mind that premium bonds can offer greater price protection than par or discount bonds during periods of rising rates.

From a credit standpoint, we believe that now is a good time to diversify and consider upgrading the quality of muni portfolios for resilience through an economic downturn.

Main contributor: Kathleen McNamara

Read the original blog Municipal market performance update 2 November 2022, which includes additional charts to illustrate these insights.

This content is a product of the UBS Chief Investment Office.