Munis showed up throughout a volatile first quarter

If only I had a crystal ball! As I sat down to pen my 2026 municipal market outlook, there were plenty of policy issues to consider. Monetary and fiscal policies as well as judicial rulings may affect the public finance ecosystem as they can influence deal structure and/or timing, volume, credit quality, market pricing, and investor flows. In my outlook, I devoted some real estate to the impact from the One Big Beautiful Bill Act and to the inflationary uncertainty surrounding broadly-levied tariffs amid a rebalancing of global trade relationships. Despite U.S. attacks on Iranian nuclear facilities last June, the emergence of a bona fide war with Iran in the first quarter of 2026 was not on my radar screen. Was it on yours?

When crafting market content during periods of volatility, the challenge many of us encounter is to artfully navigate through a myriad of shifting developments and produce a timely and relevant piece. The events of this week may be a defining moment for the Iranian crisis. The two-week ceasefire following President Trump's Tuesday, 8 p.m. ultimatum sent oil prices lower by about 15%, yet stability remains elusive and pricing is not yet back to pre-crisis levels. Already, there are accusations that the U.S. and Israel have breached several of the agreement's key points, creating operational uncertainty around the status of the Strait of Hormuz.

While the strait did technically reopen with the ceasefire, shipping volume drew uncertainty given existing backlogs, security concerns, and required approvals from Iranian authorities. Furthermore, the limited nature of the ceasefire will, for now, prevent a normalization of oil prices and bond yields.

During the opening weeks of 2026, it appeared that my expectations for the municipal bond market were being met. After another record-setting supply year, issuance was marginally net-positive with combined January and February volume, yet advanced over 20% year-over-year in March despite the Middle East crisis, concluding the quarter with an 8% overall advance year-over-year, according to LSEG data. Throughout January and February, muni returns were flashing green, yields declined, fund flows were decidedly positive, and ratios were on the richer side, particularly on the front-end.

With the February 28th attack on Iran by the United States and Israel, volatility quickly anchored the financial markets, with fixed income yields spiking along the yield curve. Oil was driven to $100+ per barrel as Iran's closure of the Strait of Hormuz prompted wide-spread supply disruption, leading to renewed inflationary fears and significantly downsizing expectations for additional rate cuts by the FOMC. Importantly, Q1 is defined by a rates-driven event catalyzed by a geopolitical shock, and not by an indictment of municipal security credit quality.

Fixed income yields found themselves in a tug-of-war as oil-induced higher inflation concerns vied for attention with a slower growth, weaker employment outlook. Given this backdrop, yield movements can best be characterized as counterintuitive in the absence of a logically expected "flight-to-quality' trade. The market bought into the notion of higher-for-longer, particularly as prospects for a rate hike entered the conversation. In my view, this was not a viable or sensible action since higher rates would significantly move the recession needle.

The U.S. Treasury benchmark 10-year yield began the year at 4.19%, advancing to a year-to-date high of 4.4% on March 27 thanks to escalating military tensions, rising oil prices with a higher long-term inflation risk premium, and supply-driven technical pressure before falling range-bound to around 4.35%. The benchmark 30-year yield, which entered 2026 at 4.86%, approached 5% on March 27, before retreating to a 4.9% trading range.

Muni yields followed a similar trajectory, albeit with more volatility, as the benchmark AAA 10 and 30-year yields rose 60 and 35 basis points respectively from lowest to highest during the quarter to underperform Treasuries. Despite March posting the worst monthly returns in over two years, muni investors still showed up in recognition of the compelling value proposition, and the resilient nature of the municipal market came forward once again, particularly on the long-end.

The temporary ceasefire was well-received across the rates and equities markets on Wednesday, with the Dow posting its best day since April 2025, as any de-escalation would be viewed favorably. Having said this, treasury yields are tentatively drifting lower given the still-present uncertainty surrounding the Middle East crisis. Municipal yields rallied to outperform treasuries as we witnessed a material repricing along the curve.

For now, rates are reacting to optimistic expectations that an off-ramp to the war is in sight with a rate hike off the table. Market participants care more about the duration of the conflict as opposed to the shifting rhetoric. In a recent speech at Harvard University, Fed Chair Powell posited that inflation expectations are well grounded and the Fed is poised to "look through" the oil price shock, obviating the need for a tighter policy move that could produce negative long-term consequences. By most accounts, the overall policy bias remains toward lower rates.

Inflationary impact

In my opinion, even under the best-case scenario whereby the military campaign ceases permanently and the Strait of Hormuz resumes normal operations as soon as possible, the added inflationary impact may take a while to dissipate. In its recently released March Survey of Consumer Expectations, the Federal Reserve Bank of New York's Center for Microeconomic Data reports that households' inflation expectations rose at the short and medium term horizons and remained unchanged at the longer-term horizon. The survey further revealed that gas price growth expectations surged to the highest level since March 2022.

I would also caution against forming overly optimistic growth assumptions. While the Federal Reserve's survey cited improved job finding prospects, job loss expectations and forecasts surrounding the unemployment rate worsened. Lastly, survey respondents indicated a more pessimistic view of their future household financial status.

Reviewing the minutes of the March 17-18 FOMC meeting, Fed officials expect a rate cut this year despite elevated inflation fears tied to the Iran war and tariffs. Committee members are more concerned over the potential impact of higher gas prices upon labor market conditions, consumer spending, and overall growth performance - getting back to the tug-of-war I discussed earlier.

Although March employment data may suggest improvement in labor conditions, let's be mindful of previous downward revisions, and I point out that many of the jobs being created tend to be low-paying, service related roles within the healthcare sector. The minutes indicate that, "The vast majority of participants judged that risks to the employment side of the mandate were skewed to the downside." Various participants acknowledged that businesses in their areas are exercising caution given concerns over the economy and the longer-term impact of artificial intelligence on the labor market.

While consensus expects inflation to move closer to target, policymakers revealed their need to stay "nimble" with respect to any inflation spike, yet indicated that it is too early to assess the ongoing developments in the Middle East and that close monitoring is needed before any potential policy shift emerges. While tariffs remain a threat, most officials view their inflationary impact as temporary. Against this backdrop, participants "judged that the risk of inflation running persistently above the Committee's objective had increased."

"Participants noted that a prolonged conflict in the Middle East would likely lead to more persistent increases in energy prices and that these higher input costs would be more likely to pass through to core inflation." Interestingly, while the futures contracts anticipate a hold on monetary policy through year-end, the ceasefire has elevated the odds for a rate cut.

Ratios and returns

Circling back to munis, ratios and returns tell the Q1 story. The sharp rise in muni yields during March altered the performance trajectory with the asset class posting a loss of 2.32% last month. At month-end, munis were showing an 18 basis point deficit year-to-date, wiping out noted gains in January and February.

State-specific returns for March followed the broader index to negative territory. In terms of curve positioning, short tenors, while negative, outperformed, with the 7-15 year part of the curve posting the worst returns. There was no performance distinction between "Aa" and "A" rated cohorts, with the "Aaa" basket being the weakest as the quality bias held no significance.

Despite these losses, investors remained focused on the prize as elevated yield and income conditions, better relative value and a steeper yield curve motivated duration extensions with new entry point opportunities. These attributes have made the "carry trade" even more pronounced, and have given top tax bracket investors something else to consider away from equities, especially when assessing taxable equivalent yields for certain spots on the curve.

With the exception of the week ending March 25, fund flows were decidedly positive during the quarter. Continued allocations across ETF and SMA platforms were evident, signaling continued engagement for these market segments. The value proposition is further supported by relative value ratios which, as pointed out earlier, began the year on the richer side, largely due to heavy demand and tight credit spreads.

The underperformance of munis, a product of geopolitics and heavy supply, has created cheaper conditions with an opportunity to book yield ahead of shifting summer technicals that often catalyze more expensive ratios. The 10-year ratio, for example, rose to 72% by March-end from 64% in early January. The 30-year ratio, starting the year at about 87%, was north of 90% at the end of March. During the summer months, reinvestment demand accelerates while new issuance tends to subside.

These opportunities can be captured at a time when municipal credit quality demonstrates resiliency. Of course, active security selection is advised given noted cracks in the credit veneer. Although states enjoy strong "rainy day" funds, there is likely to be downward pressure on those resources given declining support from the federal government, elevated inflationary conditions, heavy infrastructure investment needs, and evaporated COVID-era stimulus money. Certain revenue bond sectors, such as healthcare and higher education, are facing challenges given pricing pressure, constrained balance sheets, tighter operating margins, and competitive headwinds.

As for issuance, there is still an opportunity to post another record year. However, we have already seen several revisions to earlier supply estimates. This was a topic of conversation at The Bond Buyer's Texas Public Finance Conference held March 30 - April 1. Elevated rates can significantly alter the economics for refunding transactions, but this dynamic can shift very quickly.

Looking at the year-to-date volume figures, we see that issuers are accessing the market despite the volatility and higher rates. Issuers are likely to remain engaged given their enormous funding needs and committed issuance schedules. However, ongoing volatility can place certain issuers on day-to-day status, or result in a downsizing of the deal or even a complete cancellation for certain transactions.

In this environment, many deals are being priced to sell and dealers are working hard to limit their balance sheet exposure. For some issuers, elevated ratios with associated higher relative borrowing costs can delay their plans. In these instances, greater concession is often required to clear the market. Those issuers with greater flexibility, and certain spread-sensitive credits are in a better position to wait for improved ratio conditions.

In conclusion, duration management should be used as an effective tool. As I pointed out, duration extensions with minimal credit risk can make sense for many investors, and we are seeing this with SMA buyers. However, a more conservative approach may call for a reduction in duration exposure until the geopolitical uncertainty abates. Not to belabor the point, but careful security selection and active portfolio surveillance can go a long way to achieve relatively stronger returns.