Municipal Market Performance and Benchmark Rates: It was a broad based retreat across most, if not all, asset classes in March as the conflict in Iran proved too much to handle for investors. Surging energy prices renewed inflation fears and led to acute volatilty in the US Treasury market with bond investors demanding a higher term premium. Rates are significantly higher in March as expectations of a Fed rate cut have largely evaporated.
The US Treasury Index (LUATTRUU) posted it’s worst monthly return (1.82%) since October 2024, as rates are anywhere from 29-48 basis points higher, depending on tenor. As for the municipal market, spring is historically a difficult time of year, from a performance perspective, as the municipal market always contends with elevated supply, tax-related selling pressure, and low reinvestment demand from coupon and maturities. These seasonal technical factors, coupled with significant UST volatilty, led to underperformance in March. The Bloomberg Municipal Bond Index (LMBITR) erased YTD gains, losing (2.53%) in March, and now finds itself in negative territory year-to-date. The Bloomberg Municipal High Yield Index marginally outperformed this month, down (2.17%), and remains positive YTD at +0.43%.
Month-to-date changes in the AAA Municipal Benchmark were significant in March as rates rose by anwhere from 44 (30YR) to 62 (10YR) basis points since February 27th. While the repricing was painful to experience, there’s no question that this has created an attractive entry point for tax-exempt investors.
Mutual Fund Flows: The above mentioned broad-market forces were too much to handle for institutional municipal flows as mutual funds experienced their first outflows in 2026 at the end of March. Despite this, total inflows remain on track to be the 3rd highest on record at this point. Funds experienced inflows 3 out of 4 weeks this month, totaling $3.3B. High-yield flows were less constructive, with outlfows totaling $973M this month, ($1.2B the last 2 weeks of March) perhaps indicating a contagion of negative sentiment in other credit markets.
Primary Market Supply: The municipal new issue market experienced sustained tailwinds in March, driven by ongoing infrastructure spending and capital demands. Total primary issuance approached $50bn this month, an increase of 12% YoY and 20% higher than the trailing 5-year average for the month. High-yield issuance has been mixed YTD but as the calendar continues to build into Q2 and funds experienced outflows in the latter two weeks of the month, opportunity should persist.
The events unfolding in the private credit market provide an excellent lesson in the risks associated with a liquidity mismatch between investment vehicle and the underlying assets. It is a story we’ve seen time and time again in the high yield municipal market, where daily liquid funds are the favored vehicle for most investors. However, the bonds within these funds are “less liquid” and do not trade daily. As evidenced in private credit markets, investor behavior can be irrational and herdlike. The impact of investors “heading for the exits” at the same time can be dramatic and we have learned how liquidity crises can drive portfolio management decisions.
Whether a contagion from the exodus from private credit funds or a coincidence, municipal high yield funds reported $1.2B in outflows that last two weeks of the month. Despite the above referenced rate volatility, market activity remained relatively orderly, which we expect in the early stages of any market dislocation. Mutual funds and ETFs are required by the SEC to maintain a percentage of their assets in “highly liquid” holdings. Portfolio managers needing to raise cash to meet redemptions will first sell these assets or borrow against lines of credit. Within the high yield municipal market, there are a handful of highly liquid issuers that are widely held across fund complexes. For example, Buckeye Tobacco, which is a flagship holding of almost all high yield and many investment grade funds, sold off modestly in March, roughly 30 basis points.
However, should redemption pressure escalate, things start to get interesting. With a handful of widely held, liquid issuers, high yield municipal funds are often forced to sell the same thing at the same time. The most extreme example we can remember was at the onset of COVID in March 2020. Buckeye Tobacco came to market in February 2020 and traded as high as $115.00. By March 23, roughly three weeks and $8B in outflows later, the same bonds traded at $69.00, a 40% decline in price. After portfolio managers have sifted through and sold their “liquid assets” they are forced to sell their less liquid holdings. Selling less liquid assets for daily liquidity needs can be quite challenging. It is not uncommon for bonds to gap higher in yield by 25 to 50 basis points at a time, which creates its own negative feedback loop. Investors and analysts that are not intimately familiar with the current credit status of a borrower are often spooked by the gap in trading yields. This can lead to a diminished universe of buyers offering to purchase the securities, leading to more gapping of yields higher and prices lower. We experienced this through the Easterly Funds liquidation a year ago. As the fund was selling to meet increasing investor redemptions, we purchased one of our approved credits at ever increasing yields: 7.00%... 7.50%... 8.00%... 9.00% and finally 9.50%. At each successive purchase, the number of bidders decreased until we suspect we were the only option. As a result, we bought bonds for a credit we follow extremely closely 300 basis points cheaper than the original evaluation. Admittedly, this impacted performance in the short-run; however, we expect our investors to benefit significantly when the market stabilizes and prices normalize.
This market phenomenon frequently occurs during periods of dislocation. It is why we stress so strongly how important the vehicle is to protect investors from the irrational behavior of other investors. Providing daily liquidity on a portfolio of assets that do not trade daily is a recipe for disaster. Or, an opportunity for investors not constrained by vehicle structures. The lender of last resort sets the terms that are most favorable to their investors and those needing the liquidity are forced to accept the terms.
Whether or not we will see such extremes in the coming weeks remains to be seen. However, should the outflows and dislocation persist, we expect inefficiency to increase and opportunities to abound. Certainly, the market is setting itself up for dislocation. Supply remains high, mutual funds are experiencing outflows and technical factors are providing significant headwinds. Combined with the negative sentiment surrounding private credit funds and the rush to exits, a contagion effect is a real possibility. We will continue to watch fund flows closely and be on the lookout for any mutual funds needing immediate liquidity. We wait, with eager anticipation for just that opportunity.
The chart above shows the increase in value of $1,000,000 invested in the LCP composite at inception (net of management fees and expenses) vs. the benchmark, the Bloomberg High Yield Muni (LMHYTR) as well as the Bloomberg Muni (LMBITR) indices (it is not possible to invest in either Bloomberg Index). Please contact us with questions regarding credit profile, returns, taxable equivalent yields or further portfolio information. Past performance is not indicative of future results.