The municipal bond market continues to be impacted by interest rate uncertainty and by inflation that has proved to be “stickier” than the Federal Reserve (the “Fed”) anticipated. While the Fed decided to “pause” its series of interest rate hikes at its mid-June meeting (leaving the federal funds rate target range at its current level of 5.00 – 5.25%), the Fed also released its Semiannual Monetary Report to the Congress which reiterated Chair Powell’s belief that interest rates will rise further this year. In late June, first quarter GDP was revised up to a 2% annualized rate reflecting a resilient economy and jobs market. A stronger economy lends support to the position that the Fed has some more work to do, possibly one or two more 25 basis point rate hikes.
Notwithstanding some headwinds, municipal bonds managed to post respectable returns for the first six months of this year with the Bloomberg Municipal Bond Index providing a total return of 2.67%. The supply of municipal bonds has continued to be subdued, in part due to higher borrowing costs, with tax-exempt debt issuance down approximately 15% on a year-over-year basis. Meanwhile, demand for tax-exempt municipal bonds has been steady leading to a slight supply/demand imbalance which helped support prices. Supply is expected to remain below average through the summer months, which typically experience the highest number of bond maturities and reinvestment activity. Approximately $40 billion in reinvestment money is predicted to flow into the municipal bond market in July alone.
Municipal bond market fundamentals remain strong heading into the second half of this year. State and local government budgets continue to expand, albeit at a slightly slower pace, and credit quality remains very strong. The current default rate of investment grade municipal bonds remains below historic levels, and credit upgrades continue to exceed downgrades. With the end of the rate tightening cycle nearing and inflation abating, we believe the stage is set for municipal bonds to perform well for the remainder of this year.
A couple of sectors such as health care and senior living have seen a deterioration in credit quality. Fortunately, our investment portfolios have extremely limited or, in most cases, no exposure to these riskier sectors. We continue to favor high quality essential service revenue bonds such as water, sewer, and utility systems. We are sticking to our disciplined process of buying the highest quality bonds at the best possible yields and holding on to them as long as we can. This investment strategy has served us well for many years, and we are confident that it will continue to produce positive results for our shareholders.
Thank you for investing with us. I hope you enjoy your summer!
Allen E. Grimes, Ill President