What to Make of Recent Volatility in the Muni Market?

Yields dropped, then rose again. Is it a sign of trouble brewing in the markets? Or just a return to equilibrium?

If you were paying attention to the municipal bond market in 2021, you may have observed a drop in yields (and a corresponding rally in prices) at the end of the second quarter that continued into the third quarter. Depending on maturity, Treasury yields reached quarterly lows on either August 3 or 4. From there yields rose again modestly, then picked up momentum following the Federal Open Market Committee meeting in September.

To many investors, this V-shaped uptick in yields looked like another V word: volatility. And many investors responded to it the way they often do when volatility strikes: emotionally. But we think it’s important to keep two things in mind: First, even if this were evidence of volatility in the muni market, it’s important to avoid overreacting. That’s when investors tend to make mistakes. And second, what if this isn’t volatility at all? While it’s possible the recent sell-off is the beginning of something larger, it’s also possible the market is simply returning to a familiar equilibrium. We think the data bears this out.

As we begin the fourth quarter, it’s striking to see how little Treasury yields have changed since the end of the second quarter, as the table below shows.

Source: Bloomberg, 9/28/2021

We think what drove the rally in bond prices in early August were concerns about the potential economic impact of the coronavirus’s delta variant. As those fears have begun to ease, the focus has shifted to Fed tapering and the future normalization of short rates, resulting in a mild bear flattening of the Treasury yield curve.

As this next table shows, munis look to be underperforming Treasuries this quarter, with yield rising and the curve steepening. Yield data is taken from the Municipal Market Data (MMD) AAA Curve.

Source: Thomson Reuters, 9/28/2021

The difference in performance may be the result of a clearer picture emerging of the changes Congress might make in the tax code. Munis had outperformed in the beginning of the year due to a strong demand for tax-exempt income. At least out along the curve, the move in the third quarter would seem to be a move toward normalization of ratios, as the table below indicates.

Sources: Bloomberg, Thomson Reuters, 9/28/2021

The Fed maintains that the pace of economic growth and inflation will moderate over the next few quarters. The data seems to support that view. The Fed also sees a modest uptrend in rates, and we concur. 

The uptick in volatility in the third quarter has resulted in a V-shaped period, but so far it hasn’t taken us into new territory. We think investors should stay the course and not be disconcerted by a return to yields that were available earlier this year. With munis further out along the curve more fairly valued than they were in the spring, should the market overreact we might even see a rare fourth-quarter buying opportunity.