Revisiting ‘Muni’s’

Back in May of last year, I sent out a Market Commentary entitled “Taking Advantage of Market Dislocations.” The piece discussed the fact that yields on municipal bonds had increased above yields on US Treasury bonds of the same maturity (we used a 10-year maturity). We noted that this “dislocation” had occurred despite the improved fiscal condition of state & local governments, which was the result of both the federal government’s financial assistance during COVID as well as increased state & local tax revenue associated with rising property values, strong capital gains and solid retail sales. We said that given the dramatic improvement in state & local government finances, one would normally expect that investors would require less yield to compensate for the reduction in credit risk. We also noted that in normal times, and all else equal, yields on high-quality, investment-grade municipal bonds would be expected to be lower than yields on Treasury bonds of the same maturity. This is true, we said, because retail investors are not required to pay federal income tax on the interest they receive from municipal bonds. 

But back when I wrote that Market Commentary in May, municipal bond yields, at roughly the same level at Treasuries, were reflecting neither the tax advantage nor the improved credit profile. Yields on both types of bonds had just spiked dramatically, reflecting the increase in inflation and the expectation that the Fed would be aggressively hiking short-term interest rates to combat said inflation. But municipal bond yields had risen at a much faster clip, which didn’t make much sense. We attributed the anomaly to mutual fund redemptions that caused some forced selling by mutual fund portfolio managers. As such, we called this out as an investment opportunity. We said, “the relative illiquidity in the municipal bond markets has created an exploitable opportunity to earn outsized yields. We could be wrong, but it doesn’t seem like a situation like this will last very long. Eventually, money will come in to take advantage of the dislocation and bring conditions closer to equilibrium.”

Fast forward to today, and we indeed see a much different situation. Treasury bond yields have continued their ascent, rising over 100 basis points above the level from last May and resulting in price decreases for those bonds. However, municipal bond yields are actually down slightly over that same time frame, which means their prices may have even increased a bit. All the while, municipal bond holders were able to earn a comparable yield without incurring federal income tax!

It’s nice when things work out so nicely, but this is not always the case. Investing is a game of probabilities, and if you’re right 60% of the time you’re doing a pretty good job. That said, opportunities like this don’t come along often, and we are happy that client bond portfolios benefited from municipal bonds holding up a lot better than most everything else in the second half of 2022.