Why strong May muni returns rewarded weaker credits

With May returns fully booked, munis are the standout performer across the fixed income asset class as geopolitical uncertainty and market volatility continue to impact yield movements. May was backdropped by on-again-off-again ceasefire and "let's make a deal" talk. The Strait of Hormuz remained heavily disrupted with restricted commercial traffic and very limited energy transport. Oil kept range-bound, although prices did dip below $100 per barrel on the occasional optimistic sentiment.

U.S. Treasury yields continued to play tug of war and finished May close to where they began the month, especially the benchmark 30 year. However, volatility gripped tightly with intra-month spikes as investors repriced myriad risks thanks to inflationary pressure tied to broadly higher energy prices and data-specific economic releases. Away from geopolitics, market stakeholders grew weary of ballooning U.S. deficits and elevated interest costs on the nation's debt given swelling borrowing needs. Technical events that catalyzed selling activity further added to the self-fulfilling prophecy of embracing more conservative duration management.

Throughout May, the overwhelming consensus placed munis in the fixed income sweet spot. Spread compression across lower quality credits, carry attribution (income cash flow), strong fund flows and reinvestment posturing were all part of the success. The value of tax-exemption, particularly when considering the compelling taxable equivalent yields, resonated loudly across the investor cohorts. Recognition of the steepness of the muni yield curve continued to drive duration extensions despite the sharp volatility and uncertainty, with the asset class providing reliable portfolio ballast and solid yield and income opportunities, especially from spread products.

Parsing the Bloomberg performance data for May, returns were awash in green. The broad muni index returned 37 basis points versus 11 basis points for U.S. Treasury securities. Year to date, through May month end, munis delivered 134 basis points of return, while Treasuries were flat. Munis also outperformed the U.S. total fixed income market returns of 35 basis points and 59 basis points for May and year to date respectively.

Longer duration munis outperformed the curve last month, with the 17-22 year bucket (20 year) showing the best return (64 basis points). Again, investors were motivated to capture the benefits of a steep yield curve by locking in additional yield at a time of relatively easing - yet still very much present - geopolitical concerns. Given that muni yields ended May lower than the intramonth highs, longer durations responded more favorably to the relative price advances.

Let's recall that March posted the worst monthly muni returns in over two years thanks to escalating military tensions and rising oil prices with a higher long-term inflation risk premium. April's strong rebound coupled with May's positive returns fully wiped out the March month-end year to date performance deficit and, for now, places the broad market index on track for decent single digit returns at year-end.

State-specific returns for May were all comfortably positive and the lower grade "A" and "Baa" rating cohorts outperformed the investment grade basket. This was largely due to greater spread compression within the "Baa" rating group and higher "carry" attribution during May. Better relative value opportunities created more enticing yields for those investors willing to migrate down the quality curve. Quality attribution for May shows us that these investors were compensated for their higher risk tolerance.

The taxable muni index slightly underperformed the broader tax-exempt index in May because spread tightening was more pronounced across the tax-exempt sphere given stronger performance for lower quality investment grade tax-exempts. Further, the tighter correlation between taxable munis and treasury securities limited the upside potential for taxable munis given the less insulated volatility from macro and geopolitical developments.

Muni high yield significantly outperformed the broader index in May. A still favorable credit climate and disproportionate spread tightening within lower quality buckets drove outsized returns. I would point out that there is often greater spread to recover for the high yield sector during periods of sharp yield movements.

Clearly, muni credit was not penalized during May, but greater distinctions may emerge after the summer reinvestment season. While overall credit quality remains favorable, cracks within the veneer for certain sectors are growing deeper and, as expected, the upgrade/downgrade ratio has tightened considerably. I continue to worry about the healthcare, higher education, and K-12 sectors as well as certain pockets of local government credit. The rise in data center infrastructure needs will continue to pressure water and electric utility resources with anticipated implications for muni credit.

The muni high yield index returned 62 basis points in May with year to date (May month end) performance of 2.72%. High yield general obligation and certain essential purpose revenue bonds outperformed the broader high yield index last month as speculative buyers turned to predictability - an area of more substantive spread tightening opportunity. It was not a surprise that although positive returns were delivered by the high yield, electric, hospital, housing and education sectors, these cohorts underperformed the broader high yield index.

A discussion of muni performance must also include a technical overview. Unique muni market technicals often shield the asset class from macroeconomic conditions and geopolitics.

Without question, demand for municipal bonds was strong throughout May as investors positioned themselves ahead of the summer reinvestment cycle.

So far this year, reinvestment needs have been satisfied and I expect an even stronger appetite to meet maturing securities, redemptions, and coupon payments. Perhaps new issue activity will be challenged to accommodate this heavy demand.

Throughout May, flows into municipal bond mutual funds and ETFs were strong, providing support to last month's performance. LSEG Lipper reports aggregate inflows of about $6.98 billion, and just under $40 billion year to date. LSEG Lipper data reflects 20 weeks of inflows and 2 weeks of outflows for 2026 year to date. Interestingly, active flows were visible during times of significant market volatility. I suspect that expectations for a constructive seasonal reinvestment cycle will support the currently strong flow environment. Of course, the flow trajectory could be exposed to disruptive forces that even favorable technicals may not be able to offset.

Through the balance of the year, monetary policy will remain front and center. The Fed has a new chair and the market is eagerly awaiting guidance from Kevin Warsh. Policy direction comes down to whether inflationary concerns outweigh weaker growth expectations. With this in mind, I do not see justification for a rate cut at the June 16-17 FOMC meeting. The futures market concurs. I expect participant consensus to coalesce around elevated concerns that an unknown exit strategy to the Iranian crisis and higher for longer energy prices coupled with supply chain disruption will extend inflationary risk to the upside.

The June meeting will be replete with a revised Summary of Economic Projections and every word will be analyzed during Warsh's first press conference. I will be looking for any revised language in the associated policy statement and in the chair's comments

that removes the current easing bias, an area of participant discourse at the last FOMC gathering. While I expect the Fed to keep the funds rate unchanged, the vote may not be unanimous should the statement language fail to appease across the committee. I also believe that a wait-and-see approach would be conditioned upon stabilized core inflation data. For now, I think it is premature to hike short-term rates - but stay tuned.

As we head into the third quarter, munis are well-positioned for continued outperformance and I expect demand to absorb very active primary supply. However, investors are likely to become more discerning about credit and I continue to view careful security selection and critical portfolio surveillance as the primary strategy necessary to book favorable returns. Elevated long-end yields should continue to attract duration-appetite investors.