July was a challenging month for fixed income as global and domestic cohorts posted negative returns. Much of this performance can be attributed to geopolitical instability coupled with rising inflation expectations. Last month, Federal Reserve Chair Kevin Warsh concluded his second Federal Open Market Committee policy meeting, holding short-term rates steady while signaling a hawkish bias. Any meaningful consideration of a cut in the fed funds rate this year has evaporated. Surprisingly, economic conditions continue to demonstrate resiliency with a sanguine view on labor and productivity.
Munis took the Treasury market selloff to heart in July, with the broad market index losing 1.85%, the biggest July decline since 2003. Given the magnitude of this loss, year-to-date returns were pushed lower to 43 basis points. Let's recall, munis were the performance star at half-time, managing to insulate themselves from the geopolitical saga.
Although munis underperformed U.S. Treasuries (-1.11%) and the U.S. total fixed income market index (-1.11%) in July, the asset class is outperforming these fixed-income benchmarks (-0.84% and -0.29% respectively) on a year-to-date basis. For now, I expect munis to end the year with modest single-digit returns, subject to geopolitics, Fed policy and investor appetite. The July repricing has created compelling entry points to capture fresh yield and income opportunities, and taxable equivalent yield calculations cannot be ignored.
Credit fundamentals across the muni asset class remain stable, with most sectors displaying favorable conditions. However, cracks across the credit veneer are running deeper for certain sectors. In my opinion, much of the repricing throughout July was somewhat facilitated by technical fatigue. The key takeaway from July is municipal bond performance can diverge from credit fundamentals, particularly when technical dynamics shift along with macro uncertainties.
Reviewing Bloomberg muni performance data reveals that short duration, while negative, outperformed the maturity curve, with particular resiliency in the one- and three-year buckets. Beyond the 10-year cohort, the underperformance was more evident. The long bond, although modestly outperforming the 15 and 20-year maturities, lost almost 2.5% in July.
These results were driven by a significant selloff in long duration fixed-income assets thanks to interest rate volatility and attendant inflationary pressure. Longer-duration munis remain more sensitive to comparable-maturity Treasuries, reacting to evolving macro conditions. Although munis typically display relative insulation from such macro events, their recent price advances exposed the asset class to greater volatility and upward yield movements.
During much of the first six months of 2026, recognition of the relative steepness of the muni yield curve promoted duration extensions despite the sharp volatility and uncertainty. Munis provided reliable portfolio ballast and solid yield and income opportunities, especially from spread products. Last month, however, investors lacked motivation to capture the benefits of a steep yield curve through duration extensions and locking in additional yield.
The associated spikes in long bond yields allowed shorter maturities to provide some comfort to those fixed-income investors seeking cash-equivalent strategies. Continued growth across SMA mandates further enhanced short-end valuations and associated performance. Apart from some intermittent recovery during the month, the benchmark 10 and 30 UST yields advanced by 27 and 30 basis points, respectively, throughout July.
Like-maturity muni yields rose by 13 and 26 basis points respectively last month, yet ratios had been at very rich levels as muni yields sharply declined earlier in the summer and so munis reacted with greater volatility last month. In other words, munis had more outperformance to surrender, making the move to cheaper ratios inevitable.
Last month, lower quality credits were relatively rewarded, with high yield outperforming the broader muni index by the widest margin. This observation was created by investor pursuit of yield maximization, both on a cyclically attractive absolute and taxable equivalent yield basis. This area of the quality spectrum placed the "carry" trade front and center against a backdrop of favorable credit fundamentals and outperformance from higher yields that help to insulate portfolios during periods of extensive market volatility.
Simply put, the more pronounced outperformance from lower-quality credits was largely due to relatively less spread widening compared to higher-quality bonds and compelling "carry" attribution in July. Better relative value opportunities created attractive yields for those investors willing to migrate down the quality curve. These investors were compensated for their higher risk tolerance.
Spread products within the muni asset class can be a direct beneficiary of higher-quality-focused SMA investment activity. SMA demand tends to keep the short-end relatively rich with tighter spreads and the municipal yield curve steep. Last month, "A' and "Baa" rating cohorts lost 1.76% and 1.73%, respectively.
Looking more closely at high-yield performance attribution, I first note that muni high yield earned negative 1.51% in July. Even with this loss, high yield is outperforming the broader muni index year-to-date with a return of 2.52%. A still favorable credit climate and relatively better spread performance within high yield drove outperformance in July.
Overall, July's negative high-yield performance was highlighted by weaker returns for education, transportation and Puerto Rico, signaling a wider space for spread widening. Interestingly, high-yield electric, hospital, water & sewer, and Puerto Rico are all outperforming the broader high yield index year-to-date. Much of this reflects relatively more room for spread tightening (throughout outperforming months) as well as specific bets being placed on these sectors.
Generally, I note there is often greater spread to recover for the high-yield sector during periods of sharp yield movements. Last month, however, it was more about containing wider spreads. Interestingly, the only high-yield sector to show a positive return in July was the electric power sector. I suspect that this outlier reflects a wager placed on rising electricity demand tied to data center buildout.
The taxable muni index (-1.66%) modestly outperformed the broader muni index in July as spread widening was more pronounced across the tax-exempt sphere due to technical fatigue within the space. Although July tax-exempt issuance declined 17.5% year-over-year, taxable issuance dropped almost 56% during the same time period, thus creating a scarcity premium.
Taxable composition of shorter average duration compared to the disproportionately longer duration tax-exempt index — with heavier exposure to the effects of a long duration Treasury selloff — further supported the taxable muni outperformance. I suspect the tighter correlation that generally exists between taxable munis and Treasury securities limited the upside potential for taxable munis given their less insulated volatility from macro and geopolitical developments.
Although muni credit was not penalized during July, greater distinctions may emerge later in the year and into 2027. As mentioned, cracks in the credit veneer are running deeper across certain sectors and, as expected, the upgrade/downgrade ratio has tightened considerably. In certain sectors, such as private higher education, charter schools, K-12, and lower quality healthcare, there is evidence of downgrades outpacing upgrades. The rise in data center infrastructure needs will continue to pressure water and electric utility resources, with anticipated implications for muni credit.
Throughout July, we witnessed a steady, yet uneven, grind toward cheaper ratios from more expensive levels leading into the month — a necessary ingredient for the underperformance and not the best set-up for an obsession over a "higher-for-longer" market bias. While record supply during the first half of the year was comfortably absorbed by heavy demand, July experienced a bout of indigestion even as supply declined. Deals got done, but investors were less enthusiastic.
Breaking with the experience of the first half of the year, there were far fewer oversubscriptions on new primary offerings in July even though demand remained strong. However, investor demands for concessions were met in order for supply to clear the market. Last month, investors exhibited noted selectivity across sector types and structures.
Signs of investor appetite were evident by flow activity for ETFs and mutual funds. While inflows slowed down during the back-end of July according to Lipper data, three of the five reporting weeks showed well over $1 billion in positive flows, with aggregate flows surpassing those reported for June. Again, July was a reset with ample repricing along the curve as a way to preserve investor participation. If June was framed by selective allocations, following May's broader buy-in, July can be characterized by mutual accommodation.
LSEG reports aggregate July inflows of about $5.37 billion, and year-to-date well exceeding $45 billion. Interestingly, active flows were visible during times of significant market volatility, attesting to the strong demand for relatively favorable credit quality and compelling yield and income opportunities. I expect continued demand dynamics to support the current strong flow environment. Of course, the flow trajectory could be exposed to disruptive forces that even favorable technicals may not be able to offset.
In my halftime review, I commented that reinvestment needs have been satisfied and I expect a continued appetite to meet maturing securities, redemptions, and coupon payments. Although total July issuance declined almost 20% year-over-year, supply remained above the 10-year average and was the third highest issuance level for the month on record. Despite July's declines, issuance remains on track for another record year. Issuers are accessing the market despite the volatility and higher rates.
I expect issuers to stay engaged given their heavy funding needs and emerging budgetary constraints. While we did not see much of this activity last month, ongoing volatility can place various issuers on day-to-day status, or result in a downsizing of the deal or even cancellation of certain transactions. As mentioned, deals are being priced to clear the market and underwriters are working hard to limit their balance sheet exposure.
While I do not expect ratios to have a significant impact upon issuance, a return to more expensive ratios — with associated lower relative borrowing costs — could be a motivating force behind refunding activity. Under this scenario, greater concessions would be required less often to clear the market. Spread-sensitive credits would have better market reception at lower ratios.
Two identified factors contributing to the falloff in July supply were the FOMC meeting during the final week of the month and the June 30 fiscal year end for various states. The heavy bond market selloff last month did not have a big influence on July issuance. All in all, primary market activity adjusted well to the market repricing, with underwriters and buyers aligned to execute orderly deal flow.
The FOMC does not meet again until September 15-16, and this session will deliver a revised summary of economic projections. The Warsh Fed must pursue every effort to preserve central bank independence. With rising inflationary pressures, it may be difficult to avoid higher rates. As of this writing, the fed funds futures contracts are projecting almost a 60% likelihood of a rate hike at the September meeting. Let's recall that the July decision to hold the target range for the federal funds rate at 3.5% to 3.75% was not unanimous, as there were three dissenting votes in favor of a 25-basis-point rate increase.
A key consideration for the FOMC is to determine how restrictive monetary policy must be to keep inflation under control. Very recent history shows us that the markets cannot rely on administration pronouncements concerning the Iranian crisis — with specific status on the Strait of Hormuz. Perhaps this is not the best time for the Fed to relax its forward guidance as the markets seek central bank clarity. We are also awaiting final determinations from the newly formed task forces as to how future tools, policy frameworks and communication methods will be deployed.
