Economic and Policy Landscape
Macro conditions shifted in the third quarter as a stronger-than-expected economy, a less predictable inflation path, and a higher cost of capital reset valuations. Firm growth gave the Fed room to tighten, while financing needs tied to AI infrastructure and fiscal deficits pushed long-term yields higher. Looking ahead, however, cracks are forming in consumer savings and labor data, so we expect only two or three additional hikes, much of which is already priced into yields.
Municipal Credit Trends
Municipal credit fundamentals stayed resilient despite the volatility, with upgrades narrowly outpacing downgrades through late September and positive rating momentum building at quarter-end. Spreads also held up well relative to the rate move, as A-rated spreads tightened 5 bps and BBB spreads 17 bps. Still, slower state revenue growth, Medicaid changes and uncertain federal funding make issuer selection increasingly important.
Sector-Specific Developments
Sector returns were driven more by duration and structure than by credit. IDR/PCR led at -3.99%, while Housing (-7.42%) and Hospitals (-7.41%) lagged. Hospitals in particular face growing pressure from Medicaid changes, narrow margins and elevated labor costs. In contrast, essential service revenue bonds remain attractive thanks to dedicated revenues and the ability to adjust rates, and prepaid gas continues to offer extra yield, though valuations vary widely by structure.
Market Performance
The municipal market moved from strong summer support to a sharp September repricing, as record issuance, falling redemptions, Treasury volatility and tax-loss harvesting converged. As a result, the Bloomberg Municipal Index fell 4.36% in September, its weakest month since 2008, and 6.35% for the quarter. AAA yields rose more than 100 bps across the curve, with the 10-year reaching 4.13% and the 30-year 5.25%. Shorter maturities and higher coupons held up best, while long bonds and low-coupon structures fell the most as de minimis concerns weighed on discount bonds.
Municipal Outlook
Despite the selloff, we remain constructive heading into year-end. Yields are now at their highest levels in more than a decade, which makes taxable-equivalent income compelling, and credit remains broadly healthy. Accordingly, Sage will stay duration-neutral and continue to favor coupons of 5% and higher, new-issue concessions, and select BBB credits. Holiday trading, the midterms and Fed policy may cause short-term dislocations, but those should create opportunities to add high-quality bonds at attractive levels.
Municipal Fixed Income Allocations & Recent Change
| Sector | Positioning & Recent Changes |
|---|---|
| State General Obligation | After the pandemic-era surge, state budgets have entered a period of slower revenue growth. Estimated fiscal 2026 revenue growth was about 2%, compared with 5% in fiscal 2025. Twenty states saw revenue declines, while 30 saw increases of up to 10%. Rainy-day reserves are still elevated but below their pandemic peaks: 17 states hold balances below 10% of general-fund spending, and only three hold more than 30%. Medicaid makes up nearly 70% of federal grants to states. Provisions in the One Big Beautiful Bill Act could add budget pressure. |
| Local General Obligation | Local governments still hold reserves above long-term averages. However, investors are paying closer attention to slower tax revenue growth and possible changes to federal funding. Credit stress has stayed limited to a small group of issuers rather than spreading across the sector. Governance, recurring revenue growth, and reserve flexibility increasingly separate stronger issuers from weaker ones. Local GOs remain a preferred area of investment. Chicago is a clear example of the tradeoff: it offers high income, but fixed costs exceed 40% of net appropriations, and recent budget fixes provided temporary relief rather than structural reform. |
| Healthcare, Utilities and Transportation | Hospitals (-7.41%) were among the weakest subsectors in Q3. Medicaid changes, reimbursement uncertainty, narrow margins, and elevated labor costs weighed on the sector. We remain selective and focus on payer mix, days cash on hand, leverage and covenant compliance. Essential service utilities and transportation remain attractive because of indispensable demand, dedicated revenues and the ability to adjust rates. Transportation systems such as the New York MTA now depend more on stable tax-supported revenues and less on ridership. Heavy issuance may weigh on prices in the near term, but it also creates chances to add durable, high-quality income at attractive concessions. |
| Quasi-Corporate | IDR/PCR was the quarter's strongest subsector at -3.99%. Prepaid gas continued to offer extra yield, supported by a rapidly expanding market and a meaningful weight in municipal benchmarks. Valuations vary widely across bank-, insurance- and industrial-backed structures. That makes it important to evaluate the underlying obligor, the transaction structure, termination provisions and how much extra spread investors are paid. We favor selective exposure where strong structural protections come with attractive relative value, rather than broad sector allocations. |
Outflow Cycles Can Be Painful But Also an Opportunity for Outsized Returns
Since 2003, the municipal market has gone through 12 major outflow cycles. They lasted 23 weeks on average, and their triggers ranged from Fed tightening to credit scares. Across these cycles, the Muni Index fell 3.96% at its low and then gained 5.21% over the following three months. Thirty-year bonds rebounded 7.07% after a 6.82% decline, and BBB credits gained 5.61% after a 7.88% decline. September’s repricing was the market’s weakest month since 2008. History suggests that investors who stay invested and add selectively are rewarded, but the window to act tends to close quickly.
Municipal Curve Long-End Rolldown Returns Are Very Appealing
The steep AAA curve offers a compelling “roll-down” opportunity beyond 10 years: as bonds age, they move to lower-yielding points on the curve, which adds to their return. Estimated total returns rise from 2.46% at 1 year and 4.16% at 10 years to a peak of 5.32% around 21 years, well above the curve’s underlying yields. This provides a cushion against further rate increases. If the 10s30s curve, now 112 bps, flattens back toward normal, longer bonds would gain additional principal. This supports the Core Strategy’s barbell, where bonds in the 17- to 22-year range capture much of the long end’s yield and carry with less volatility.
