The Good News Is We Have Muni Data Back To 1821;}
The municipal bond market continued its downward trajectory in the second quarter, resulting in the worst first half in the history of the bond market, which dates to 1821. The rising fear of inflation and the uncertainty of how far the Federal Reserve needs to hike short-term interest rates injected massive uncertainty and fear, which is always a bad combination for fixed income markets.
The municipal bond market, which usually outperforms in a rising rate environment, was hit even more than taxable markets as investors pulled out historic amounts of cash. This led to a negative return of -2.94% for the Bloomberg Municipal Bond Index, -6.59% for the Bloomberg Long Term Municipal Index, and -7.24% for the First Trust Municipal Closed End Fund Index.
Retail investors were selling anything they could in a relatively illiquid market, which caused prices to fall precipitously. The selling led to higher tax-exempt yields relative to their taxable counterparts and offered savvy buyers a relative discount on municipal bonds as too much negativity was priced into the market.
From the ICI:
As difficult as the market was for individual bonds, closed-end funds were down over twice as much as the index and offered tax equivalent yields close to 11%. Based on the lower-risk nature of municipal bonds, these types of yields are rarely achieved.
Additionally, discounts on closed-end funds widened to levels not seen in over five years. We believe this should add to performance as the discounts narrow. Longer dated bonds have the potential to add increased average yield and in the case of expected inversion of the yield curve could lead to longer dated bonds outperforming shorter dated bonds.
Looking forward, we expect the Federal Reserve to continue hiking short-term interest rates to fight inflation. Unfortunately, we also believe that due to inflation and a relatively aggressive Federal Reserve, the economy is headed for a slow down if not an outright recession.
Economic indicators are starting to come in weaker and economists are raising the chances of a recession every day. If this scenario does come to fruition and the economy weakens significantly or even goes into a recession, we would expect long-term yields to fall and for an inversion in the yield curve to occur.
The municipal bond market should react in a similar fashion and could outperform the taxable market due to significant negativity already priced into tax-exempt bonds