How’s it going to be?

Shadow of the Day

Like many other bond investors, we enjoy periods of quiet boredom as our portfolios steadily provide their income — as long as the stillness does not last too long. Opportunities often flourish during periods of dislocation, and it is then that managers can better distinguish themselves from one another. When market storm clouds cast their dark shadows, investor sentiment suffers, volatility rises, and selling often follows. Some say tough times build character. We prefer to think that tough times reveal character — or, for bond managers, the strength of their strategies and investment processes. The COVID-19 pandemic catalyzed the most volatile investment environment since the 2008 global financial crisis. Last spring, Liberation Day tariff announcements sent markets reeling. Now, after the municipal market began 2026 with historically strong results, it turned decisively negative following the onset of hostilities in Iran. Only time will tell where we go from here.

After storming out of the gates with a 2% return in January and February, the municipal market abruptly reversed course in March. This was the third-worst March in the last 30 years, trailing only 2020, which suffered under the onset of the pandemic, and 2022, which fell under the weight of aggressive tightening by the Federal Reserve (Fed). This year’s problem stems from the conflict in Iran and its adverse consequences for inflation and the federal budget. Since military operations began, crude oil has spiked 50%. The Strait of Hormuz, a pinch-point for 20% of the world’s crude oil, remains virtually closed, halting fertilizer and helium exports from the region as well.

Throughout the years, we have observed that sentiment swings in municipals tend to exceed those in other areas of the bond market, likely due to the household-dominated ownership of municipals. Periods of negative returns harm sentiment, which leads to industry fund redemptions, which further hurt returns, and so on. Often lost in these negative flow cycles are the attractive investment opportunities that emerge, which is why we preach, “Don’t go with the flow.” Leaning into such periods tests your mettle and requires stable client capital. In this regard, we consider ourselves fortunate as most of our clients share our constructive view of volatility. A stable capital base provides large benefits during times like this.

The Fed finds itself in a difficult position as it seeks to achieve its dual mandate of full employment and stable prices. As inflation declined over the past couple years, the Fed eased policy 175 basis points (bps)¹ to support the labor market. We entered 2026 with investor expectations of two rate cuts, with the first around midyear and the second near year end. That expectation has since disappeared, with stable policy priced in for the rest of the year. Some investors are beginning to worry that rate hikes may be required to combat rising inflation risks. However, there is little that tighter policy can do to offset supply-induced inflation without also introducing major economic and financial system risks. Unfortunately, the Middle East conflict has cast a long shadow that will magnify affordability issues already plaguing the country. In the absence of a recession, Kevin Warsh, if confirmed as new Fed Chair, will have an even more difficult time convincing the Federal Open Market Committee (FOMC) to ease policy.

While the two-year yield ended first quarter 2026 virtually unchanged, yields increased 25 bps to 35 bps for the rest of the municipal curve. The 30-year yield ended the quarter at 4.50%, within 20 bps of its post-pandemic high. These moves, however, belied their intra-quarter volatility as you can see from the chart below. March’s unusually high volatility stands out historically.

The quarter’s higher yields led to -0.30% returns for our intermediate benchmarks. Consistent with recent history, returns across the investment grade rating spectrum were close, with lower-rated bonds enjoying a marginal benefit. We are happy to report that our portfolios generated positive returns, outperforming their benchmarks by over 50 bps. In addition to our yield advantages, we benefited from our 15- to 20-year exposures along the yield curve which outperformed the 10-year sector (8 to 12 years). The proliferation of one- to 10-year separately managed account (SMA) programs has compressed generic, high-quality yields inside of 10 years due to their high demand. This has steepened the municipal yield curve, further improving roll-down opportunities, particularly in 15- to 20-year maturities.

Our team had a busy first quarter, adding a range of opportunities in bonds with a variety of structures. Single- and multi-family housing bonds continue to offer attractive valuations. We added planned amortization class bonds (PACs) and agency-backed multi-family bonds with spreads of 95 bps to 110 bps. We purchased a 10-year prepaid energy floating rate note backed by Morgan Stanley with a discount margin of 145 bps. We also participated in two delayed delivery deals for the State of Wisconsin and El Paso Independent School District in Texas. Both deals offered attractive pricing discounts relative to our fair value estimates. Lastly, on the heels of insurance company selling, we added New Jersey Transportation Trust Fund Authority zero-coupon bonds with 11- to 15-year maturities and spreads ranging from 65 bps to 80 bps.

From a credit standpoint, we began 2026 with uncertainties brought by 2025’s One Big Beautiful Bill Act (OBBBA). This legislation, along with other federal-level tax and policy changes, has introduced funding risks, predominantly for hospitals and states. Market valuations do not reflect these risks, and now additional shadows have been cast over the municipal market.

Investor sentiment related to private credit has turned negative given recent defaults and restricted redemptions. Many would not consider the private credit market as connected to municipals, but direct exposures exist via prepaid energy bonds that are backed by insurance companies. Prepaid energy bonds are issued to fund a specified quantity of gas or other energy, usually for a municipal utility, at a discounted price. In recent years, funding recipients have expanded beyond banks to include insurance companies. Often, these insurance companies share a parent company with alternative asset managers who have increased their exposure to private credit. We scrutinize prepaid energy transactions with care, only considering those in which we are comfortable with their guarantors, structures, and energy off-takers.

Perhaps most concerning has been the escalation of conflict in the Middle East, on top of other international tensions. We do not know how long the conflict will last or how commodity price changes will progress from here. We also see a range of potential credit impacts. On a macro level, the conflict presents risks to general economic activity and inflation as higher fuel costs leach into higher transportation costs and consumer goods prices. Many families have already been struggling with affordability issues that have now intensified. On a micro level, bonds backed by motor fuel- and vehicle-related taxes could struggle if road traffic declines. To address this risk, we stress-test such bonds using different shock scenarios both pre- and post-purchase.

After rallying strongly since last summer, the municipal market suddenly fell as hostilities in Iran began at the end of February. Downturns such as this cannot be reliably predicted; neither can their length or their severity. What is predictable, however, is our approach to downturns when they occur. As in the past, we will carefully manage liquidity and lean in. Staying nimble and disciplined will remain our focus. While shadows may loom, with solutions not so simple, we continue to adhere to our investment criteria to not only protect our portfolios, but also to capitalize on opportunities. Our team and strategy are prepared for times like this.