Why Higher Treasury Rates Are Challenging the Muni Market

We have written many times this year on the support the municipal market has received from the provision in last year’s tax bill that eliminated advanced refunding transactions. Through September, tax-free municipal issuance is down approximately 14% versus the first nine months of 2017. Lower supply is one of the reasons why municipals have produced flat returns through September, while most other investment grade sectors have sold-off with the rise in interest rates.

Of course, this positive technical environment has not just been due to a supply reduction, but also because of steady demand. For much of the year, flows into municipal bond funds has been solid, with net flows (inflows minus redemptions) hovering in slightly positive territory.

This dynamic has changed over the last four weeks. For the first time since late 2016, the muni market has now experienced four straight weeks of net outflows. According to Lipper, flows for the week ended 10/17 were ($636mm), which brought the four-week average to ($495mm).

Unsurprisingly, this has coincided with a rise in Treasury yields. Historically, when US Treasury rates experience a sharp move higher, municipal flows turn negative. Because the municipal market has such a large retail investor base, we tend to see reaction based selling. In other words, when bond prices are selling-off, retail is quick to reduce exposure.

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So far in this redemption cycle, the market has held-in fairly well. We typically assess market health not just on overall performance versus other investment grade sectors, but also on how lower-rated credits are performing relative to higher-rated credits, the subscription levels of new issuance and our anecdotal trading observations. In all three areas, we haven’t seen anything that would cause significant concern. We will be paying close attention in the coming weeks however, not just how the market is trading, but how fund flows are evolving.

Source: JP Morgan, Lipper