Macros, Markets and Munis
Municipals posted the worst weekly return over the past year and underperformed Treasuries as markets remained focused on the US-Iran conflict, with oil surpassing $100 per barrel following an attack on Saudi tankers in the Red Sea. Treasury yields rose 9-15 basis points (bps) across the curve during the week amid inflation concerns. High-grade municipals underperformed, moving 18-22 bps across the curve due to declining demand and heavy supply. This week we touch on valuation impacts following the underperformance of munis.
Demand Softened as Supply Remained Elevated
Fund Flows ($174 million of net inflows): During the week ending July 22, weekly reporting municipal mutual funds recorded $174 million of net inflows, marking a 14th consecutive week of inflows but down approximately 90% from the prior week, according to Lipper. The short-term category led demand with $102 million of inflows. The intermediate-term category recorded $66 million of inflows and the long category reported $36 million of outflows. Last week’s inflows bring year-to-date (YTD) inflows to $58 billion.
Supply (YTD supply of $341 billion; up 10% YoY): The muni market recorded $14 billion of new-issue supply last week, up 7% from the prior week’s level. YTD new-issue supply of $341 billion is 10% higher than the prior record-issuance year, with tax-exempt issuance up 11% year-over-year (YoY) and taxable issuance up 3%, respectively. This week’s calendar is expected to remain steady at $14 billion. Largest deals include $1.3 billion Henry Ford Health System (MI) and $1.0 billion AdventHealth Obligated (CO) transactions.
This Week in Munis: Rich Ratios
The municipal market sold off last week and underperformed the broader Treasury market amid elevated interest-rate volatility, as higher oil prices renewed concerns about inflation and the outlook for monetary policy. The Bloomberg Municipal Bond Index returned -1.19%, its worst weekly return over the past year, compared with a -0.64% return for the Bloomberg U.S. Treasury Index.
The underperformance did little to meaningfully alleviate rich high-grade valuations, at least as measured by traditional AAA municipal-to-Treasury ratios inside of 10 years. Entering the week, high-grade municipal valuations appeared particularly challenged in shorter maturities, with 2-, 5- and 10-year municipal-to-Treasury ratios averaging 61%, 61% and 65%, respectively, in 2026. This is well below their corresponding 10-year averages of 67%, 69% and 76%, respectively. At these levels, traditional high-grade municipals offered relatively limited incremental value versus Treasuries, even for investors subject to the highest federal marginal tax rate. Following the week’s underperformance, ratios increased by only 2%-3%, remaining well below their longer-term averages.
Although municipal-to-Treasury ratios are commonly used as primary indicators of relative value in the broad muni market, they do not provide a complete picture of municipal valuations. Despite today’s relatively low ratios, the after-tax yield advantage offered by munis, assuming the top federal marginal income-tax rate, remains above its five-year average. This underscores that, in a higher nominal-rate environment, investors may rationally accept lower municipal-to-Treasury ratios to achieve greater after-tax yield pickup as tax exemption increases at higher rates.
Muni-to-Treasury ratios also focus almost exclusively on the highest-quality portion of the market, and AAA securities represent only approximately 23% of the investment-grade municipal index. When the after-tax yield advantage is evaluated across the broader credit spectrum, including AA, A, BBB and high-yield securities, relative value remains elevated relative to five-year averages. We believe investors able to access the full municipal credit landscape are well positioned to identify attractive income and relative-value opportunities, even in a tight ratio environment. For investors who prefer the highest-quality securities, richer AAA valuations may also favor strategies with the flexibility to allocate to more liquid taxable fixed-income securities within their municipal portfolios when those securities offer better after-tax income.
Municipal Credit Curves and Relative Value
Theme 1: Municipal taxable-equivalent yields remain elevated relative to historical averages.
Theme 2: Munis offer attractive after-tax yield pickup vs. taxable alternatives.
Theme 3: The muni curve remains steep and offers relative value in longer maturities.
