Muni yields are easing, and tax-loss harvesting is part of the story. Here is what it means for your portfolio.
The Signal
Municipal yields have eased roughly 10 basis points over the past week, though they remain elevated compared to two months ago. Steady reinvestment demand, lower supply, institutional repositioning, and relatively stable rates have buyers picking up paper.
We suggest investors remain focused on optimizing yield, while cautiously navigating pre-holiday dynamics and tax-loss harvesting through the balance of the year. The Federal Reserve meets October 27 and 28, and we cover what to expect below.
Last week, we noted that munis tend to lag Treasuries and that we would be surprised to see a sustainable rally from one inflation report alone. Yields have since eased about 10 basis points, helped by tax-loss selling and reinvestment demand, and we still expect one more Fed hike before year-end.
What’s Driving It
Reinvestment Demand and Fund Flows
Bid lists have been heavy over the past two months, and October has been a heavy redemption month. ETFs are taking in large inflows, while money is leaving open-end muni funds and moving into individual bonds, a continuation of the shift we described earlier this month.
Tax-loss strategies are a large part of the story. Many investors are using them to move out of mutual funds and individual holdings within the muni sector. Those shifts have supported the market, and in our view they are most likely a big reason yields have fallen over the last couple of weeks. Lower supply has helped as well, since higher rates have kept some issuers on the sidelines.
The Fed Is Giving Nothing Away
September’s CPI and PPI reports both came in hot, yet Fed Chair Kevin Warsh used his last opportunity to speak before the October blackout period to say very little. At the IMF and World Bank annual meetings in Bangkok on October 16, he did not preview the October decision, and markets expect the Fed to hold steady when it meets at the end of the month.
That fits how Warsh operates. He makes few comments in his speeches, and as we read it, he pays more attention to the trend in the market than to any single month’s data, letting the market dictate what the Fed does. We are on the fence for the October meeting, but we still expect one quarter-point hike before year-end.
Housing Slows, and Spending Is Expected to Follow
Confidence among US homebuilders fell to a 14-year low this month. The National Association of Home Builders/Wells Fargo gauge of housing market conditions dropped 3 points to 29, the lowest since June 2012, and below the median estimate of 31 in a Bloomberg survey of economists. Mortgage rates above 7%, labor shortages, elevated supply costs, and higher gas prices are all weighing on the market. Our point is a simple one: higher yields mean higher mortgage rates, and higher mortgage rates mean a slower housing market.
Consumer spending has exceeded most expectations over the past two years, and we believe income will continue to support consumption next year. Based on Bloomberg data, we expect the savings rate to remain low as we head into 2027, and real spending to slow for the balance of this year and keep slowing into 2027.
The AI Trade Looks Shakier
The AI trade has looked shakier in recent weeks as financial conditions tighten and rates move higher. We think that uncertainty will most likely extend through the balance of the year, and should the Fed hike, we would expect the AI trade to come under further pressure.
Our Take – Sloppy Markets
In an environment of tight spreads, we continue to favor higher quality credits while keeping a blend of sectors in your portfolio. We also continue to prefer the longer end of the curve, where you can lock in tax-exempt yields above 5% on AA rated paper, and we stay mindful of call dates.
We expect yields to remain elevated whether or not the Fed hikes this month. This could be a good time to continue adding to your muni portfolio, while you determine whether you need tax losses for the balance of the year. Capital continues to flow into our market, and we do not expect that to slow over the next couple of months.
Although supply has been lower because of rising rates, we believe both issuance and bid lists will remain elevated as we head into the balance of the year. That gives buyers plenty of opportunity to be selective.
There are risks to this view. Firm inflation data, a Fed that moves sooner than we expect, or further pressure on equities could push yields higher before they settle, and bond prices would fall along with them. The October 27 and 28 Fed meeting, tax-loss activity, and Treasury yields are what we are watching most closely. We will keep you posted.
Recommendations
Keep adding to your municipal portfolio at elevated yields
We expect yields to stay elevated whether or not the Fed hikes this month, and capital continues to flow into the market. That leaves time to add in steps rather than all at once.
Decide whether you need tax losses before year-end
Tax-loss selling has been a meaningful part of the market, and the holidays are approaching. If a swap could help your tax situation, we would welcome a conversation about it alongside your tax advisor.
Stay with higher quality credits and a blend of sectors
Spreads are tight, so credit selection matters. We continue to favor the longer end of the curve, where AA rated paper offers tax-exempt yields above 5%, and we look closely at call dates on every offering.
Use heavy supply to be selective
With issuance and bid lists expected to stay elevated, there should be plenty of paper to choose from. Take your time and buy what fits your objectives. Reach out if you would like to discuss any of this in the context of your portfolio.
Let’s Talk
If you would like to discuss any of the above in the context of your portfolio, reach out. This market environment rewards preparation — and that is exactly what we are here to help with.
