Municipal Bonds: Where to Find Opportunities in a Volatile Market

Municipal-bond investors have endured a roller-coaster ride with the usually steady muni market experiencing significant gains and losses since early 2022. Yet, while such volatility has given some investors heartburn, it also has provided a boon for shrewd bargain-hunters.

Federal Reserve interest-rate hikes hit munis hard in 2022, and much of the sector recorded double-digit losses and historic outflows from mutual funds even as the credit quality of muni issuers remained strong. Results improved in 2023 but were uneven. After a promising start to the year, muni returns remained negative through the end of October 2023. An impressive rally in November and December thrust the market into positive territory for the year and started to woo back weary investors. In fact, gains in 2023′s last two months resulted in some of the best relative returns across the fixed-income landscape. On average, strategies in the muni-national long and high-yield muni Morningstar Categories earned 7.0% and 6.7%, respectively, over the 2023 calendar year. However, while strong, that still didn’t make up for the double-digit losses endured in 2022.

Many hoped 2024 would bring luster back to the sector, but it got off to a slow start. The muni market was mostly flat through the end of May with returns muted by an increase in the supply of investment-grade muni bonds offered and uncertainty around the Fed’s “higher for longer” message. While June hasn’t always been kind to muni investors as redemptions often increase, the sector rallied this year. Strong credit fundamentals and some of the highest yields in decades finally brought consistent inflows back to muni strategies and boosted total returns, particularly in high-yield muni bond funds.

The changes have been clear in the shifts of the muni/Treasury ratio, which compares muni-bond and US Treasury yields to guide investors toward investment opportunities. The M/T ratio historically hovers near 80% to 90%, with anything over 100% suggesting that munis are a very good deal as they’re yielding more than a comparable US Treasury. After being relatively elevated throughout 2022′s challenging markets and floating near or above 90% for much of the year, ratios dipped to near-historic lows across the muni curve at several points in 2023 as the market rallied. As investors crept back into muni funds throughout the first half of 2024, that measure rose and stood near 80% by midyear.

While the choppy waters aren’t appealing to all investors, many municipal portfolio managers see the market volatility as an opportunity to uncover attractive valuations. For example, the muni strategies included in the Morningstar FundInvestor 500 are managed by talented teams with sophisticated tools and have performed well compared with most category peers during both robust and challenged muni markets.

Specifically, funds from the muni-national intermediate category, including Vanguard’s attractively priced intermediate muni funds, Fidelity Intermediate Municipal Income FLTMX, and T. Rowe Price Summit Municipal Intermediate PRSMX, all lost less than their average rivals throughout the difficult markets of 2022. That was also the case when munis sold off at the end of 2020′s turbulent first quarter. The same held true for muni-national long funds offered by these firms as well as T. Rowe Price Tax-Free High Yield PRFHX, which fared better than its average peer in the high-yield muni category.

These funds also fared well over longer periods, reporting volatility-adjusted results that topped most peers over the trailing five- and 10-year periods ended July 31, 2024. These strategies provided reliable downside protection in previous bouts of market stress and solid long-term returns through their use of strong risk tools and fundamental research.

This article first appeared in the July 2024 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.