Municipal Monthly

October Municipal Market Update: Examining End‑of‑Year Trends Amid High Absolute Yields

We review the latest developments in the municipal bond market and discuss how high absolute yields, coupled with a historically supportive end-of-year environment, may offer an attractive entry point for investors.

Absolute value in focus: Contextualizing today’s high absolute yields and looking ahead toward end-of-year trends in the municipal market

Despite performance woes across fixed income this year, now may be a good time to invest in municipals. Weak performance has recently resulted in a reacceleration of outflows from municipals, which has historically been an opportune time to put money to work. Amid signs that the Federal Reserve (Fed) intends to keep baseline lending rates elevated for longer, municipal yields have surged to their highest point in over a decade. In particular, the 2-year, 10-year, and 30-year tenors of the AAA Municipal Market Data (MMD) curve peaked at 3.70%, 3.61%, and 4.57% in October, respectively – the highest for each respective tenor since 2007, 2008, and 2011. On a taxable-equivalent basis, these yields translate to 6.25%, 6.10%, and 7.72%, respectively. Meanwhile, the yields to worst of Bloomberg’s Municipal Bond Index and High Yield Municipal Bond Index sit in the 99.7% and 86.1% percentiles, respectively, over the past 10 years.

While municipals faced technical headwinds in September and October due to net positive supply, November and December typically exhibit net negative supply. In fact, over the past five years, November and December have averaged -$5 billion and -$10 billion of net supply, respectively. Estimations for net supply in the final two months of 2023 are not quite at these levels, but still sit at -$1 billion and -$6 billion, respectively. Further reinforcing expectations for a more favorable technical backdrop, visible supply as of 30 October sat at just $3 billion, the lowest since late January. This presents a tailwind for the asset class, paving the way for what we anticipate will be stronger performance for municipals heading into year-end, especially if history serves as an indicator. In fact, the Bloomberg Municipal Bond Index has experienced negative returns through the year’s final two months in just three of the last 20 years, with the most recent being 2016. Similarly, the Bloomberg High Yield Municipal Bond Index has posted negative returns through this two-month period in just five of the past 20 years.

In summary, although munis appear on track for their second straight calendar year of negative returns, yields within the asset class have climbed to their highest levels in over 10 years and historical supply/demand trends – in addition to current negative net supply estimations – favor the asset class as we enter the final two months of the year. Perhaps this presents an attractive entry point for new money, as the sell-off may have reached a point where demand is expected re-emerge. For more information on PIMCO’s Municipals platform, backed by the power of one of the world’s premier fixed income managers, please visit our homepage here.

* Taxable-equivalent yield assumes 37% federal income tax and 3.8% Medicare investment tax.

October month in review

Despite strong economic data, the Federal Open Market Committee (FOMC) held rates steady for a second consecutive time at its early November meeting. During the press conference which followed the meeting, Fed Chair Jerome Powell said nothing to suggest an additional hike this year, but did not explicitly rule out the possibility. Fed officials indicated a “higher-for-longer” approach for rates as a tightening measure geared toward cooling the economy and taming inflation. Currently, the target federal funds rate remains in a range of 5.25%–5.50%.

In October, municipal yields continued to rise across the curve, though to a lesser degree than in September. The 1-, 5-, 10-, and 30-year tenors of the AAA Municipal Market Data (MMD) curve closed the month at 3.76% (+6 bps), 3.51% (+10 bps), 3.61% (+16 bps), and 4.57% (+23 bps), respectively. Tax-exempt municipal yields currently sit at their highest levels in over a decade on an absolute basis. In states with the highest individual income tax rates, notably California and New York, we saw a number of high quality tax-exempt municipal bonds reach double-digit yields on a taxable-equivalent basis.

The sell-off of U.S. Treasuries similarly extended into October, but also at a more modest rate. Yields increased at all tenors except the 1-year tenor of the Treasury curve. In particular, the 1-, 5-, 10-, and 30-year tenors ended the month at 5.46% (-1 bps), 4.82% (+21 bps), 4.88% (+27 bps), and 5.02% (+32 bps), respectively.

Municipal valuations relative to Treasuries at the end of October sat at generally similar levels as they did at the end of September. At October month-end, ratios at the 1-, 5-, 10-, and 30-year tenors of the curves were 69%, 73%, 74%, and 91%, respectively, compared to September’s month-end ratios of 68%, 74%, 75%, and 92%.

As markets continued to price in the Fed’s “higher-for-longer” sentiment and as sell-offs persisted through October, U.S. Treasury and municipal indices recorded a second consecutive month of losses. The Bloomberg U.S. Treasury Index lost -1.21% (-2.71% YTD), while the Bloomberg Municipal Bond Index declined by -0.85% (-2.22% YTD). The most significant losses came at the long end of the curve. Meanwhile, the Bloomberg High Yield Municipal Bond Index declined by -1.60% (-1.60% YTD) and the Bloomberg Taxable Municipal Index returned -2.05% (-1.19% YTD).

At the beginning of the month, heightened market volatility resulting from bond sell-offs generally discouraged issuers from listing new deals. Some issuers and underwriters opted to postpone pricings, while many deals were listed as day-to-day status. Nevertheless, this trend reversed as October progressed, and municipal issuance ultimately picked up. The month concluded with total new issuance of $37 billion, up $7 billion from September’s figure and exceeding October 2022’s figure of $30 billion. Outflows from municipal bond funds continued through October, bringing year-to-date outflows to $8.7 billion.

In the U.S. public finance sector, positive credit-rating momentum has shown signs of slowing. The third quarter of 2023 was the first since the first quarter of 2021 in which downgrades outpaced upgrades: Public finance issuers saw 25 upgrades and 27 downgrades, according to Fitch. Despite this shifting in credit revisions, we believe the overall credit rating outlook remains stable, as the majority of high-grade municipal issuers have used the past few years of robust revenue growth to strengthen credit fundamentals and generally remain very well-positioned to weather a cooling economy.

Figure 1 is a table showing AAA Municipal Market Data (MMD) yields, U.S. Treasury yields, and taxable-equivalent municipal yields as of October month-end, specifically at the two-year, five-year, 10-year and 30-year tenors of each curve. The table shows that AAA MMD yields climbed across the curve, rising by as much as 23 basis points in October, while the Treasury curve also increased, to a greater extent. Taxable-equivalent yields on AAA municipal bonds ranged from 6.20% at the 2-year tenor, 5.93% for the 5-year, 6.10% for the 10-year tenor and 7.72% for the 30-year tenor in October. Taxable-equivalent yield assumes 37% federal income tax and 3.8% Medicare investment tax. A separate box below the table includes a few additional data points, such as year-to-date municipal issuance of $319.6 billion, year-to-date municipal fund flows of -$8.7 billion, year-to-date investment grade municipal performance of -2.22%, and year-to-date high yield municipal performance of -1.60%. Data is sourced from Bloomberg, The Bond Buyer, PIMCO analysis of Bloomberg data, Thomson Reuters, and Refinitiv Lipper, all as of 31 October 2023 except for muni fund flows, which are as of 1 November 2023.

Figure 2 is a line graph that tracks the after-tax spread between municipals and Treasuries throughout the period beginning 1 November 2018 and ending 31 October 2023. The average after-tax municipal spread to Treasuries over this five-year period is 42 basis points at the 10-year tenor and 15 basis points at the 2-year tenor. Both the 10-year and 2-year spreads spiked briefly in early 2020, coinciding with the COVID outbreak. At present, the after-tax municipal spread to Treasuries is above the 5-year average for both the 2-year and 10-year tenors. Data is from Thomson Reuters TM3 MMD Interactive as of 31 October 2023. The 2-year and 10-year average spreads were calculated over the last five years, starting 1 November 2018. Data assumes a 37% federal income tax rate and a 3.8% Medicare tax rate.

Figure 3 is a bar graph showing the month-over-month change in AAA MMD yields for both tax-exempt and taxable muni bonds from the 1-year tenor through the 30-year tenor. Yields on tax-exempt munis rose across the entirety of the curve in October. Similarly, taxable muni yields also rose, except for the 1-year tenor. Data is provided by Thomson Reuters TM3 MMD Interactive as of 31 October 2023.

Figure 4 consists of eight tables. These include municipal index returns, monthly municipal fund net flows, average monthly visible supply, secondary market activity, 10-year municipal vs. 10-year Treasury yields, monthly new issuance, monthly bond redemptions, and sector returns. Sources for the data include Bloomberg, Thomson Reuters TM3 MMD Interactive, Investment Company Institute, PIMCO analysis of Bloomberg data, and The Bond Buyer as of 31 October 2023.

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