The municipal bond market continued its downward trajectory in the second quarter, resulting in the worst first half in the history of the bond market, which dates to 1812.
The rising fear of inflation and the uncertainty of how far the Federal Reserve needs to hike short-term interest rates injected massive uncertainty and fear, which is always a bad combination for fixed income markets.
The municipal bond market, which usually outperforms in a rising rate environment, was hit even more than taxable markets as investors pulled out historic amounts of cash. This led to a negative return for the Fund of -5.38% versus -2.94% for the Bloomberg Municipal Bond Index, -6.59% for the Bloomberg Long Term Municipal Index, and -7.24% for the First Trust Municipal Closed End Fund Index.
The municipal market was decidedly negative for the second quarter which led to a significantly oversold condition.
Retail investors were selling anything they could in a relatively illiquid market, which caused prices to fall precipitously. The selling led to higher tax-exempt yields compared to their taxable counterparts and offered savvy buyers a discount on municipal bonds as too much negativity was priced into the market.
Looking forward, we expect the Federal Reserve to continue hiking short-term interest rates to fight inflation. Unfortunately, we also believe that due to inflation and a relatively aggressive Federal Reserve, the economy is headed for a slow down if not an outright recession.
Economic indicators are starting to come in weaker and economists are raising the chances of a recession every day. If this scenario does come to fruition and the economy weakens significantly or even goes into a recession, we would expect long-term yields to fall and for an inversion in the yield curve to occur.
The municipal bond market should react in a similar fashion and could outperform the taxable market due to significant negativity already priced into tax-exempt bonds.
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