Everyone (It Seems) Loves Municipals

After many months of expensive pricing relative to treasuries, municipal bond prices began to capitulate this week. Together with treasury price weakness, longer term municipal bond prices are breaking down with yields jumping upwards.

Last month we discussed that the bond market correction was hanging on by a thread. By mid-month it appeared the correction phase was intact as ten-year treasury yields moved from 4.73% on April 25^th to 4.31% on May 16^th (all prices and yields per Bloomberg). The spirited move saw some sympathy with two-year treasury notes (from 5% down to 4.70%), but just a few days later the two-year note is back to 4.95% on May 24^th.

Remember, it is the shorter-term treasury yields that shape Federal Reserve policy, not the other way around. With short-term treasury bills and two-year notes at or near their highest yields for the year, this trend is not encouraging.

If there is such a thing in the bond market as everyone on one side of the boat, it is the duration trade. With yields on bonds at levels investors have not seen in years it seemed to make sense to buy some longer bonds to take advantage when the Federal Reserve lowers interest rates again. This could help explain bond prices rallying nicely in last year’s fourth quarter. Municipal bonds were trading about 75% of treasuries (ten-year maturity basis) to begin the move in October and later hit a record low of 57% in March, further amplifying municipal bonds bounce up in prices.

It is a great narrative and the one that almost everyone believes…”just look at the market performance vis-à-vis where bonds are priced!” Yes, yields are higher than the next-to-nothing the market ALSO priced in several years ago. Interest rates were nearly zero along with the Federal Reserve policy to keep interest rates lower, not just for longer, but perhaps forever. No one could seemingly remember inflation. So much for bond pricing as an indicator of the future!

The trend for interest rates is higher. The fourth quarter “rally” is a correction of the first move up in interest rates and represents a selling opportunity for investors who did add duration last year when treasury yields were high and municipal bonds offered large(r) spreads. It is not the time to load the boat with duration but instead it is a time to empty the boat of long duration.

The current rally, excuse me, correction, is running out of steam. Treasury yields are moving higher since year-end, but more importantly municipal bonds are getting cheaper again. For the last six months municipals have traded at 63% of treasuries or lower (58% all-time most expensive on March 18^th). This week we hit 67%, and at a time of rising treasury yields, causing municipal bond prices to take a double hit.

I do not know how long longer-term bond municipal bond prices continue to hang in, but the trend in the market is towards lower bond prices, particularly longer duration bonds. Sure 4% or better yields look enticing (see the Fort Worth, TX Water And Sewer Revenue Bonds below), but they represent a bet that the correction will continue to hang in and you know when to sell when it ends, not to mention the chance it may already be over.

Meanwhile we have better options as you know, along with a different definition of duration and longer-term bonds. Perhaps the current volatility in the markets is just what we need to shake loose more worthwhile bonds for your portfolio.

City of Fort Worth, TX

Water and Sewer System Revenue Bonds, Series 2024

AA+ S&P Under AA Fitch Under

Due 2/15   Dated 6/18/24 Maturity 2/15/54

$148,305,000 Sold

Years   Maturity       Coupon        Yield*

1         2025             5.00%           3.45%

2         2026             5.00%           3.33%

3         2027             5.00%           3.23%

4         2028             5.00%           3.11%

5         2029             5.00%           3.06%

6         2030             5.00%           3.16%

7         2031             5.00%           3.16%

8         2032             5.00%          3.17%

9         2033             5.00%          3.18%

10       2034**          5.00%          3.19%

11       2035**          5.00%          3.21%

12       2036**          5.00%          3.25%

13       2037**          5.00%          3.31%

14       2038**          5.00%          3.43%

15       2039**          5.00%          3.50%

16       2040**          5.00%          3.60%

17       2041**          5.00%          3.70%

18       2042**          4.00%          4.00%

19      2043**           4.00%          4.00%

20      2044**           4.00%          4.00%

21      2045**           4.125%        4.125%

22      2046**           4.125%        4.125%

23      2047**           4.125%        4.125%

24      2048**           4.125%        4.125%

25      2049**           4.25%          4.25%

26      2050**           4.25%          4.25%

27      2051**           4.25%          4.25%

28      2052**           4.25%          4.25%

29      2053**           4.25%          4.25%

30      2054**           4.25%          4.35%

*Yield to Worst (Call or Maturity) **Callable 2/15/33

Source: Bloomberg

This is an example of a new issue priced the week of 5/22/24

Prices, yields and availability subject to change