Financial Industry Insights from Advisors Asset Management


AAM Viewpoints — Why Isn’t the Municipal Yield Curve as Flat as the Treasury Yield Curve?


On April 1 of this year, the 30-year Treasury and 2-year Treasury inverted (“30-2 inversion”) for the first time since the Great Recession. Since that inversion, the Treasury curve has remained relatively flat, even recording a second 30-2 inversion just a few weeks ago on June 14. During the 2nd quarter (Q2) of this year, the spread between the 30-year Treasury and the 2-year Treasury yields has never exceeded 50bps (basis points), according to Bloomberg’s Generic Treasury Indices.

Source: Bloomberg

A flat yield curve with multiple inversions has many macroeconomic implications that have recently been discussed in AAM’s Viewpoints commentaries, but the topic we will be addressing here is the contrast between the Treasury curve and the Municipal yield curve. The Municipal bond curve has exhibited a much more traditional structure with much lower yields on the short end compared to 10 years and beyond. Over the same Q2 time period that the 30-year vs 2-year Treasury spread never exceeded 50bps, the Bloomberg AAA municipal Callable yield curve has traded as wide as 135bps between the 30-year and 2-year yields. Additionally, as you can see in the chart below, the spread between the 2-, 10- and 30-year yields has remained much more consistent than Treasuries.

Source: Bloomberg

BVAL Municipal AAA Yield Curve: The curve is populated with high quality U.S. municipal bonds with an average rating of AAA from Moody's and S&P. The yield curve is built using non-parametric fit of market data obtained from the Municipal Securities Rulemaking Board, new issues, and other proprietary contributed prices. The curve represents 5% couponing. The 3-month to 10-year points are bullet yields, and the 11-year to 30-year points are yields to worst for a 10-year call.

Municipal bonds with maturity ranges 10 years and longer have remained much closer to overall Treasury yields, but inside of 10 years, we never saw the spike in yields that was observed elsewhere. For Q2, the Bloomberg valuation yield for a 30-year AAA Municipal bond traded at an average of 101.957% of Treasuries, so over that time, you were able to invest at a higher yield on a AAA tax-free municipal bond than the yield on a taxable 30-year government bond. 10-year municipals were in a similar position trading at an average of 91.822% of Treasuries over the same period. The short end, by contrast, was trading at much lower percentages of Treasuries. The three-month average for a AAA 5-year municipal bond was 80.746% of Treasuries and the three-month average for a AAA 2-year municipal bond was 76.516% of Treasuries.

Source: Bloomberg

So why have municipal yields not experienced the same yield volatility between maturities? And why has the short end of the municipal curve remained exceedingly strong in the face of overall market volatility and overwhelming outflows from municipal bond mutual funds?

The first part of the answer to those questions comes from the municipal supply that has come to market this year. In the first six months of 2022, municipals have not kept pace with the new-issue supply that came to market in 2020 ($484.6 Billion) or 2021 ($475.3 Billion). At the start of the year, issuance projections for 2022 ranged from $550 billion on the high side to $390 billion on the low side and we are barely on track to meet the low end of that range with only $201.556 billion coming to market through the end of June. This 15% drop in supply from the previous year has created a challenging environment to find bonds each month as investments mature or are called away and we have seen surprisingly high demand for new issues as they come to market despite overall bond market conditions. Keep in mind, according to The Bond Buyer at the start of the year, $195 billion was set to mature and $105 billion was expected to be called or pre-refunded. Increasing cost of capital for public finance and persistent inflation will likely continue this trend through 2022 and many analysts have revised their full-year projections downward.

Source: Bloomberg | Chart data through July 6, 2022

The supply side of the equation is straightforward showing lower year-over-year supply that contributed to stabilizing municipal bonds during an absolute rise in rates. The demand side, however, is a little more complicated. After an extremely strong year of inflows into municipal bond funds last year, this year has been primarily defined by outflows from mutual funds. As of June 29, the total outflow number for 2022, according to Refinitiv Lipper, is $47 billion.

Source: The Bond Buyer / Refinitiv Lipper

The year-to-date (YTD) outflow numbers would seem to suggest that cash is pouring out of the municipal market at an unrelenting pace, but when we look at YTD fund flows for exchange-traded funds (ETFs) only, $10.34 billion of inflows have actually been added to the municipal ETF market. The interest rate volatility in 2022 has helped ETFs gain significantly more market share this year and ETFs are adding dollars despite the headwinds facing the market.

landrum6_071122Source: Bloomberg

The ETF data, along with consistent demand on the short end of the curve despite lower yields, seems to suggest that rather than completely pulling their funds from municipals, investors are rather re-allocating to a more flexible and conservative strategy in an uncertain market. This trend is consistent with what we have seen this year on the trading desk at AAM. Demand for tax exemption has remained extremely high with the caveat that maturities must remain on the short end of the curve. However, simply buying short maturities in this environment leaves quite a bit of yield on the table that is available in other parts of the curve. Inflation numbers are consistently coming in over 8% and cost of capital is increasing, so investors potentially should be able to put their money to work at higher rates. The strategy we suggest in this market is to manage duration rather than maturity. The intermediate part of the curve provides much higher absolute yields at much higher percentages of Treasuries, but we are primarily looking at bonds with higher coupons, shorter calls and a modified duration under five years.

Municipal bonds have obviously had their missteps this year while adjusting to the increases in interest rates, but the value of tax-exempt investments remains strong, and we expect many more opportunities to present themselves in municipals as the year continues.


CRN: 2022-0708-10155 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit


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