Roller Coaster

Breathtaking, heart-pounding, even a little scary. A roller coaster? No, this year’s municipal bond market. But just like those coasters, the municipal market started 2026 on a steady incline, earning 2% through February, before turning into a wild ride. The twists and turns of the Iran war, inflation, tariffs and historically high federal deficits drove significant volatility and, ultimately, a sharp and abrupt decline in third quarter 2026. Indices experienced a veritable freefall, with the full market declining over 6% – its worst quarter in the last 35 years. What is scary to some can be exciting to others, and while returns may be down, the yields that are available today are the best they have been in 20 years. That’s something we will always line up for!

Chair Kevin Warsh inherited a divided Federal Reserve (Fed) and a series of difficult challenges when he took office in May. Once rare, dissents within the Federal Open Market Committee (FOMC) have become more common. As recently as July, the FOMC voted 9-3 to keep policy on hold. These dissents, along with public criticism of the Fed, have raised questions about its independence. However, despite pressure from the federal administration to cut rates, in September the Fed unanimously voted to hike rates by 25 basis points (bps)¹ to 3.75%, ending its two-year easing cycle. At quarter end, fed funds futures implied 100 bps of rate hikes over the next 12 months.

Chair Warsh has vowed to contain inflation, but monetary policy has limited power over inflation driven by war-related oil constraints and tariffs. Persistent inflation is compounding existing affordability pressures. Even if the Fed brings inflation down to its 2% target, the country’s price levels and financial burdens on households will remain elevated. We appreciate that the Fed asserted its independence while recognizing the economic and political difficulties ahead.

During third quarter 2026, other macro factors, such as heavy borrowing to fund artificial intelligence (AI) infrastructure, also weighed on the U.S. bond market. As hopes for a near-term resolution to the Iran conflict faded and were replaced with expectations of tighter monetary policy, the municipal market experienced one of the largest selloffs in recent decades. Tax-loss selling further strained the market. As a result, municipal yields surged across all maturities and ended September at levels not seen since before the global financial crisis (GFC). For the quarter, the five-year yield increased 115 bps to 3.75%; the 10-year yield increased 115 bps to 4.10%; and the 20-year yield increased 110 bps to 4.85%. Combining their yield and roll-down, 10- to 15-year maturities now offer the best risk-adjusted return potential across the municipal yield curve.

Rising yields bring falling returns, and for third quarter 2026, our intermediate benchmark returned -5.09%, resulting in a -3.77% return year to date. We are pleased the strategy outperformed the benchmark by 55 bps for the quarter and 123 bps for the year. Our holdings of bonds in niche sectors and nonstandard structures continue to provide a yield advantage. In addition, our conservative method of valuing callable bonds helped protect our portfolios. Callable securities often offer tempting yields but lack real value, and their downside risks become particularly evident during bear markets. As in 2022, outsized yield increases raised the effective duration of callable securities, which magnified their price declines.

On the supply side, municipal issuance remains strong, reaching $491 billion year to date, with school districts, hospitals, water/sewer, and prepaid energy transactions leading the way. Although the market remains on pace to set a new supply record this year, cracks are emerging as several large deals were recently postponed. Thus far, the supply has been well received, and elevated yields, higher municipal/Treasury ratios, and a steep curve should help support demand. There remains the risk that, despite attractive valuations, household investor sentiment becomes negative given the extent of this quarter’s losses. As we have highlighted in the past, sentiment and value can, and often do, diverge.

Despite this year’s volatility, credit spreads remained surprisingly stable even as downgrades outpaced upgrades by nearly a 2:1 margin. We remain focused on the impacts of changes in federal government spending on healthcare, higher education, and transportation infrastructure. Most recently, the expansion of AI infrastructure has added another twist. Concerns around data centers are broad, spanning rising utility costs, electric and water capacity, and growing unpopularity among nearby residents. Many people want to use AI as long as the data center is far from home!

We do not invest in bonds directly related to data centers. However, we do monitor exposure to large end-users in our utility and prepaid energy bonds. Our portfolios typically hold about 5% to 10% in utility bonds and 15% to 20% in prepaid energy bonds. Utilities that serve data centers will need to address demand growth and related infrastructure costs (such as for new generation capacity), as well as how to recover those costs. In evaluating utility systems, we assess a variety of factors, including capacity as well as their legal ability and economic flexibility to recover costs. Prepaid energy transactions fund discounts for electricity and gas purchases by various end-users, so while customers may include data centers, the discounts achieved could help offset the potential upward pressure on rates. The credit risk of a prepaid energy bond primarily depends on the credit profile of the ultimate borrower – typically a bank or insurance company – known as the funding recipient. Our analysis centers on the structure of the underlying transaction, and we collaborate with our corporate analysts to assess the durability of the borrower.

Third quarter 2026 provided a good reminder of why we view volatile markets constructively. We added a wide range of opportunities across sectors and bond structures. We purchased several floating rate prepaid energy bonds with spreads between +120 bps and +160 bps. The banks involved in these deals included RBC, Morgan Stanley, and Citigroup. We also added a 10-year fixed rate prepaid energy bond guaranteed by Bank of America at a spread of +145 bps.

We continued to find attractive risk-adjusted value in the housing sector, both in single-family, predominantly in three- to six-year planned amortization class (PAC) bonds, and in multifamily Freddie Mac-guaranteed 12- to 14-year bonds. In both subsectors, bonds are heavily backed by federal guarantees and provide spreads approaching 100 bps. We also added utilities, including a four-year put bond for San Antonio’s gas and electric system at +70 bps, and two-year put bonds for Waste Management at a spread of +100 bps. Lastly, we purchased New York City Transitional Finance Authority and State of New York personal income tax revenue bonds, with spreads of +30 bps to +70 bps. Heavy issuance has widened spreads for these two very high-quality credits.

Because there is no easy path to solve today’s challenges, we expect elevated market volatility. Investing when markets are stressed can feel like riding a new roller coaster in the dark, knowing that your stomach may drop at any moment. While we are not thrilled about the steep drop in returns, we have successfully managed through many highly volatile periods before. Historically, the investments we make during times like this typically provide meaningful benefits. Our playbook remains the same: ensure that our credits are durable, manage portfolio liquidity, and lean into the growing number of opportunities. We try to avoid getting caught up in the optimism of good times, and we tend to be very active when sentiment is poor.

Our team remains focused, and we thank you for your continued trust and confidence.