Municipals Thoughts from the Municipal Bond Desk

Tim: Geopolitical headlines have been fueling volatility across financial markets this summer, pushing yields higher in a lot of asset classes. Munis hadn’t felt that same pressure until recently. Why’s that?

Mark: Well, munis tend to march to their own beat. Performance tends to be driven more by supply and demand than by geopolitical headlines, and both stayed supportive through mid-July. Supply was manageable, and municipal mutual fund and ETF flows stayed positive. There was also still a lot of separately managed accounts (SMA) cash waiting to be put to work.¹ That combination helped munis hold up even as the broader backdrop grew more challenging. However, oil prices and inflation fears came back to the forefront, as the US and Iran traded attacks and shipping through the Strait of Hormuz slowed to a near standstill. Muni yields rose alongside US Treasury yields during the first full week of July, with higher crude oil prices and hawkish Federal Reserve (Fed) commentary pressuring the broad fixed income market.¹ While inflation showed signs of improvement in data that was released mid-month and Fed Chair Kevin Warsh adopted a more dovish tone, I expect uncertainty about the inflation outlook to continue fueling interest rate volatility, which is likely to weigh on muni performance in the near term.¹

Tim: So, the recent pullback didn’t signal a fundamental shift in market conditions?

Mark: No, it didn’t. I see it as a pause rather than the beginning of a broader trend. As Treasury yields rose across the curve, muni yields largely followed, leaving relative value little changed. In fact, I think muni valuations have stayed fairly rich, leading to more selective buying by investors, as new issuance continues at a steady pace. Demand remains a key source of support. Muni bond mutual fund and ETF inflows extended to a 14th consecutive week, albeit at a much slower pace. Seasonal July reinvestment cash provided a strong technical backdrop, and new issues were well received, with pricing tightening after issuance.² Credit fundamentals also remained favorable, with upgrades continuing to outnumber downgrades.² I expect Fed monetary policy to be a key consideration in the coming weeks. Stronger economic data is likely to keep interest rates higher for longer and contribute to near-term volatility, but I believe recent muni weakness was more a reflection of the broader move in Treasury yields rather than deteriorating muni fundamentals. With demand remaining healthy and supply continuing to be absorbed, the recent pullback looks more like a normal market adjustment.

Tim: The Trump Administration has paused more than $1 billion in federal Medicaid reimbursements to California and Minnesota.³ Does this action raise credit concerns about either state?

Mark: I don’t think so. The Trump Administration said the pause was part of a broader effort to strengthen oversight of federal health care spending, not a reduction in Medicaid funding. The review will be focused on claims with documentation gaps or those identified through fraud detection analytics, with federal officials stating the funds would be released once the requested documentation is provided. In my opinion, the pause isn’t a credit concern. The deferred amounts — $867.5 million for California and $199 million for Minnesota — are relatively small compared to each state’s overall federal Medicaid funding. They represent less than 1% of what each state receives.³ California receives roughly $100 billion annually in Medicare funding, while Minnesota receives about $10 billion annually.³ We'll keep an eye on the resolution timeline, but given the small dollar amounts relative to each state's overall funding, we view this as a headline to monitor rather than a credit event to act on.

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