Summer loving had me a blast…
Summer loving happened so fast…
Summer days drifting away…
It turned colder, that's where it ends…
Summer dreams ripped at the seams…
The summer winds were more like Category 4 hurricane conditions for fixed income, and more specifically for the muni bond market with accelerating yields retracing all of the positive performance — and then a lot more — booked during the first half of 2026.
Admittedly, the third quarter kept market participants on edge as an elusive exit ramp for the Iranian crisis kept oil prices elevated. As we know, oil is entrenched in the global economy, impacting everything from supply chain logistics to wholesale and retail prices. Against this backdrop, it is fair to say the bond market wagged the stock market's tail during September.
The markets would benefit from less political rhetoric and actual progress to restore geopolitical stability. Movement through the Strait of Hormuz appears to have loosened up, yet safety and security concerns remain unabated and elevated shipping costs tied to transport logistics are contributing to still-higher oil prices.
The midterms are upon us with policy issues, inflation, affordability worries, and geopolitical crisis placing a dark cloud over November 3rd. Should Congress turn blue, a divided government is likely positive for bonds, particularly if spending appreciably slows.
In my view, solid disinflationary momentum goes hand in hand with stabilizing forces, and even so, not likely at the pace most of us would prefer. The Federal Reserve spoke with a loud voice in September by raising the fed funds rate 25 basis points to a target range of 3.75%-4.0%. The vote was unanimous, perhaps being more about a unified front and Fed independence than divergent viewpoints.
Let's recall the July vote to hold rates steady was met with dissents from three regional Fed presidents who favored a rate increase. With the removal of some policy accommodation, rates remain distant from a restrictive backdrop, but getting closer.
As expected, the policy statement was devoid of forward guidance, yet the rate hike was meant to prompt a "timelier return" to the central bank's 2% inflation target. The Summary of Economic Projections (SEP) signaled a hawkish bias, with the median "dot plot" indicating
Economic activity appears to be expanding at a solid, yet uneven, pace, with resilient spending and strong productivity. However, with the latest employment data, job gains are lagging workforce growth as hiring slows down. The uptick in the unemployment rate to 4.2% may signal a cooling labor market. Inflation remains elevated with continued risk to the upside. During the post-meeting press conference, Fed Chair Kevin Warsh stated "trends matter," arguing that individual data points are "noisy."
September was a defining month for the municipal bond market. Performance turned negative on both a month-to-date and year-to-date basis for the first time this year. Bid-wanted activity accelerated, supply remained elevated despite the volatility, certain deals were moved to day-to-day status or pulled entirely, fund flows turned negative, the trend of fewer oversubscriptions continued, and investor demands for concessions mounted in order for supply to clear the market.
Investor selectivity deepened last month across sector types and structures. Generally, the primary market adjusted to repricing conditions, with underwriters and buyers focused on orderly deal flow. Dealers remain committed to manageable balances and communications with investors were timely and transparent.
Munis entered September with a negative bias following August's selloff — which produced a 23-basis-point loss in the broad Bloomberg market index. Throughout last month, munis struggled to catch a bid thanks to deeper technical fatigue and an embattled Treasury market. However, muni yield swings were more dramatic (interday and intraday) than Treasury movements throughout September, particularly during the last week of the month.
Value opportunities loom for the patient and resilient long-term muni investor who recognizes that the asset class is not in Kansas anymore. Such a fertile environment results from a delayed catch-up to Treasury yield movements, erratic market technicals and active tax-loss harvesting. Given the current rate-centric environment, the muni bond market currently rivals risk assets, providing both attractive absolute yields and cash flow while representing a safe haven for risk-off investors seeking to expand portfolio diversification and capture tax-efficiency.
While rates can move higher, there is an opportunity cost for waiting to access the market. Locking in today's compelling cash flows allows the "carry" attribution to help alleviate the potential losses caused by further principal erosion. If it were not for the "carry" attribution last month, September's muni returns would have likely shown deeper losses. With the looming Federal Open Market Committee meeting and the rising probability of divergent economic data points, rates could remain under upward pressure for a bit longer.
Nevertheless, a recovering Treasury market and more favorable muni technical conditions may be good enough to push tax-exempt yields lower. The opening days of October witnessed improved sentiment with wide bumps along the muni curve, given renewed Treasury buyer interest seeking yield and income opportunities, dovish Fed signals ahead of the "blackout period" and softer inflation and employment data.
Despite some give-up in relative value, muni yields remain attractive with compelling taxable equivalent yield calculations, and we are seeing very active exchange-traded fund commitments.
Proper messaging is critically important and, given the protracted uncertainty, it is a fool's game to predict the bottom — akin to trying to catch a falling knife. Roughly 45% of the Treasury 10- to 30-year curve repricing year-to-date came last month. Adjustments of this magnitude do not occur with regularity and can be traced only a handful of times since 2000. These instances were all followed by a material recovery.
History shows that when money re-enters the market, the flow moves quickly. Investors are advised to stay engaged, explore credit and structure opportunities, seek out relative value, and remain well-diversified. As always, preservation of principal is the prime directive.
Consistent resiliency has provided the underpinnings for a functioning U.S. bond market. Nevertheless, it is becoming more challenging to deny the presence of a secular bear market for global bonds given the losses revealed by the Bloomberg Global Aggregate Performance Index. The era of zero and below-zero interest rates with ultra-accommodative monetary policy and seemingly endless amounts of cheap money has faded to distant memory.
We are witnessing generational peak yields driven by surging debt levels with heavy sovereign borrowing needs and accelerating domestic defense spending. Artificial intelligence and corporate Capex infrastructure debt — particularly from hyperscalers — competes against traditional Treasury and corporate debt issuance, and geopolitical shocks are contributing to inflation premiums.
Hyper-scaler debt is having a distortive impact, and while forecasts can sometimes undermine the ability to be nimble, corporate earnings are expected to remain favorable. Reinvestment activity is being met with higher yielding opportunities and new issue allocations benefit from more attractive entry points. Carry attribution underscores compelling investment choices across the fixed income sphere.
Watching bond yields these days is like looking at a runaway train, yet perhaps the train is carrying some unconventional monetary tightening baggage that we hope could possibly signal a conclusion to the Fed's tightening cycle. Volatility does give rise to higher levels of market liquidity concerns, yet I do not anticipate any significant dislocations over the coming months. However, it is important to recognize that liquidity pressure is being felt on a global scale and it will likely take a stabilizing rate trajectory to create relief.
U.S. Treasury yields spent the month of September attaining new highs, with the 2-, 10- and 30-year U.S. Treasury benchmarks advancing 49, 50, and 37 basis points, respectively. The 30-year is now at its highest level since 2002. While the accelerated rise in bond yields originates from outside of our beginning-of-the-year base case, identifying a conclusion to the Treasury market sell-off comes with great challenges.
With absolute deference to the stickiness of inflation, the Fed's tightening bias may extend beyond one and done. Nevertheless, this does not suggest the Fed needs to raise rates at every meeting, as the devil will be in the data. The weaker-than-expected September labor report (+29,000 non-farm payrolls) relieves some of the pressure on the Fed to combat inflation.
Much of the modest job creation was driven by lower-paying healthcare employment. Downward revisions to July and August removed a combined 60,000 jobs from previous estimates. One of the most stunning observations for 2026 is how quickly expectations for rate cuts at the beginning of the year evolved into resounding calls for tighter policy, leading to concerns of hiking rates against a supply shock backdrop.
Attention must be paid to the tightening of the 2s/10s spread as the relationship is moving closer to inversion (72 basis points at the beginning of the year and 45 basis points as of this writing). An inversion of this part of the Treasury curve is typically a harbinger of recession. Recession was not part of my base case heading into 2026, but unforeseen circumstances cannot be ignored. While I do not anticipate recession to set in next year, the balance of risks has shifted, given uneven growth expectations and swelling leverage conditions.
Evidence of a resilient economy — with the uncertainty surrounding growth, employment and consumer participation — fosters the higher rate backdrop, with Treasury market technicals and rising federal deficits and debt adding to the upward pressure on yields. Although the consumer remains engaged, consumer sentiment does not align with present activity, and any material consumer withdrawal could impact growth to the downside.
Over the near-term, the impact of higher borrowing costs on credit cards and mortgages will receive scrutiny. The tricky part for the Fed is to slow consumer and business spending by elevating borrowing costs and reducing demand to alleviate upward price pressure just enough without sending the economy into recession.
Consumer spending remains a leading contributor to economic expansion, exposing the headline growth figure to softer performance should consumer engagement move closer to reported sentiment.
Further, the bifurcation of the consumer between the higher and lower income cohorts is likely to impact actual performance, and adds dimension to a "K-shaped" economy. In the Fed's September SEP, median FOMC forecasts for gross domestic product (GDP) in 2026, 2027 and 2028 are 2.3%, 2.4%, and 2.2%, respectively. In my view, these forecasts are most exposed to downward adjustments in subsequent SEPs.
Geopolitical uncertainty and price instability are not catalysts for growth, and future GDP prints can be expected to trail today's performance should geopolitical uncertainty persist. The third and final estimate for second quarter GDP shows the U.S. economy grew at a faster-than-expected annualized rate of 2.2%, somewhat lower than a revised Q1 GDP of 2.5%. While energy shocks tend to be short-lived, we may have to be flexible with the definition of short-lived, and we must be careful not to overly rely on core inflation as a predictor of future inflation.
John Mousseau, CIO of Cumberland Advisors, states, "The length of the conflict (versus early perceptions it would be a short-term conflict) and resulting higher oil prices have changed market perceptions to higher-for-longer inflation. With that, this has contributed to higher real rates as investors price a potentially longer period of restrictive monetary policy and have been requiring more term premium as a result."
The AI buildout is tied to interest rates, spreads, and current yield curve dynamics. The market has priced in much AI growth already. It is unlikely that a 25- or 50-basis-point rate hike will undermine data center buildout activity, and beyond the AI infrastructure capital needs, AI safety investment is likely to accelerate in 2027.
The Bloomberg municipal index reveals a loss of 4.36% in September, pushing year-to-date returns to -4.18%. My initial expectations for moderate single-digit returns seem unattainable at this point, but ending the year in the "green" is not impossible. Improved technicals and relief to geopolitical tensions could be accretive to muni performance.
U.S. Treasury securities outperformed the broad muni index in September, posting a loss of 2.24%. Year-to-date, munis are now trailing Treasuries (-2.77%), and U.S. corporates (-3.11%). During Q3, munis lost 650 basis points of return, versus a 305-basis-point deficit for Treasuries. Of course, munis finished the first half of 2026 at much higher returns, thus were positioned to retrace more performance ground.
Throughout September, benchmark MMD AAA 10- and 30-year yields advanced 86 and 60 basis points, respectively. Similar maturity Treasury yields rose 50 and 37 basis points, respectively. Parsing the Bloomberg muni performance data, one- to four-year maturity buckets, although negative, outperformed the curve in September, with the 12-year and out maturities significantly underperforming, and the intermediate part, or the belly, still under pressure.
With interest rate volatility and inflationary pressures well-entrenched, September witnessed a meaningful selloff in long duration fixed-income assets. Much of the muni underperformance and wider yield swings last month can be attributed to various technical conditions. The noted upward yield pressure within the belly of the muni curve during September, assisted by last month's rate hike, drove relative value ratios to much cheaper (attractive) levels. Cheaper valuations, should they persist, may allow the belly to absorb further rate shocks.
Throughout September, the 10-year ratio moved from 72% to a high of 80%, elevating institutional investor interest and driving cross-over buyer participation. For high net-worth buyers, taxable equivalent yields offered in the belly were highly compelling. Nevertheless, a combination of surging rates, challenging technicals, and yearend tax-loss harvesting — via liquidations of underperforming mutual fund positions — upended a 21-week run of positive flows.
A closer look at flow activity reveals a major structural shift out of conventional open-end mutual funds into municipal ETFs having lower fees and relative transactional ease. Tapering seasonal cash reinvestment needs against an ongoing wall of supply contributed to the negative environment as liquidations were executed into a weak secondary market.
Last month, the AAA rating bucket tracked the broader muni market index (-4.36%) and only the AA rating cohort outperformed (-4.28%). High-yield only slightly outperformed the broader index (-4.31%) in September. Through September year-to-date, high yield lost 1.68%. Given earlier outperformance from the high-yield sector, there was more ground to give up during September's sell-off as speculative investors lowered their risk tolerance with attendant spread widening across the space.
Evidently, high-yield performance capitulated and left the "carry" trade at the door last month as duration became a casualty of September's poor performance. The depth of institutional holdings forged a repricing of the high-yield risk premium across the broader high-yield space. Selling pressure was particularly noted across weaker, thinly traded names entering a very illiquid market last month.
Noted high-yield underperformance in September was shown in the housing, transportation, education and Puerto Rico sectors, signaling a broader space for spread widening. The 8.24% loss in the high-yield transportation index can be attributed to the Brightline bankruptcy. At this point, there are no widespread contagion fears over the Brightline bankruptcy. It is hard to believe the market was caught off guard. While structural provisions should protect Brightline muni principal, changes to the legal contract and interest payment deferments have led to downgrades and distressed conditions.
Taxable munis outperformed the broader muni index in September, losing 3.18%, as spread widening was more visible across the longer duration tax-exempt sphere due to technical fatigue. Intermediate-term taxable munis stood in better relative position compared to their tax-exempt counterparts, and taxables did not experience the selling pressure and tax-loss harvesting shown on the exempt side.
Supply continues at a rigorous pace despite the outsized volatility, with
Despite the calendar adjustments, issuers were very present last month. Certain issuers have little choice but to access the capital market for immediate funding needs, while others want to get ahead of additional rate hikes. It came as no surprise that refundings were down more than 25% in September, given the surge in bond yields. Issuance through yearend is expected to be met with favorable, yet potentially hesitant, reception.
Given current yield and income opportunities along with cheaper entry points, cross-over buyer interest as well as renewed commitments from banks and insurance companies may occur. While we cannot rule out further intermittent weekly outflows, I do not anticipate a cyclical shift away from positive flows.
The FOMC meets next on October 27-28, and this session will not be accompanied by a revised Summary of Economic Projections. Referring back to my earlier comments, it is not necessarily a foregone conclusion that the FOMC will raise rates for the second consecutive meeting. Fed funds futures are currently pricing in a 34% probability of a 25-basis-point rate increase this month.
Tax strategies are highly employed in 2026
Muni portfolio management utilizes effective tax strategies, such as tax-loss harvesting in 2026. Cyclically historic levels of interest rates create fertile ground to harvest losses in many municipal bond portfolios holding securities acquired at significantly lower yields. The current rate environment has created lower price entry points on higher coupon bonds and opportunities to sell lower coupons — long 3% and 4% munis that were originally purchased at premiums and are now trading at discount levels — and acquire 5% (or close to) coupons. As always, investors are encouraged to consult with their tax advisor before entering into a swap.
A municipal bond swap is accomplished by selling certain bonds in a portfolio with the sale proceeds reinvested in other similar — but not identical — municipal securities, in an effort to take advantage of present market conditions and/or tax considerations. There are different types of swaps and they are generally transacted in order to realize one or several specific portfolio objectives. These would include:
- Reduce tax liability
- Adjust to changes in interest rates
- Adjust maturity/duration
- Consolidate portfolio holdings
- Enhance returns
- Diversify a portfolio
- Adjust call protection
- Adjust credit quality
One of the most often used types of swap transactions is the tax-loss swap. A tax loss
The swap effectively creates a real loss from a "paper" loss, which can be used to offset taxable gains of up to $3,000 of ordinary income per year. Such realized gains can be derived from the sale of various capital assets, including equities, real estate, a business or other fixed-income securities. Unused losses can be carried forward to reduce tax liability in future years. Keep in mind that subsequent tax treatment of capital gains and losses may be altered by tax reform.
When completing a tax loss swap, another goal is not to materially disrupt portfolio performance. Furthermore, bond swaps for tax purposes must adhere to current Internal Revenue Service regulations. For example, the IRS would disallow an offset to capital gains if the swap creates a "wash sale." The IRS does not permit a tax loss from the sale and subsequent repurchase of the same or "substantially identical" security within 30 days. While "substantially identical" often carries subjective interpretation, avoidance of the "wash sale" rule can generally occur if the two bonds materially differ on issuer, coupon or maturity (two of the three are preferred).
Investors typically prefer to maintain overall portfolio credit quality, par value and annual tax-exempt income. However, tax-loss swaps can be used to enhance yield and/or reallocate among sectors. It is generally recommended that investors consider tax-loss swaps before liquidity tightens at yearend as transactional costs tend to be somewhat heavier given liquidity constraints.
