The US municipal bond market endured its most severe monthly drop in nearly two decades in September.

Persistent inflation concerns and the ongoing risk of interest rate hikes kept pressure on the fixed-income market, driving municipal bond yields sharply higher and causing notable losses for investors.

The Bloomberg Municipal Bond Index fell approximately 4.4% in September, marking its worst monthly performance since the collapse of Lehman Brothers in September 2008.

At the same time, municipal bond yields climbed to their highest levels since at least 2011, with long-duration bond prices taking a particularly heavy hit.

Ongoing US-Iran tensions have intensified market worries about inflation, while the risk of further rate hikes from the Federal Reserve remains a significant factor weighing on the bond market.

In an environment of broadly rising yields, longer-duration municipal bonds are more sensitive to interest rate changes, making their declines especially pronounced.

However, signs of stabilization began to emerge this week.

Municipal bond prices rebounded for a second consecutive day on Thursday, ending a nearly two-week losing streak, and funds started flowing back into related ETFs.

Yields climb to multi-year highs, municipal bonds face concentrated selling

According to Bloomberg-compiled data, the 10-year municipal bond benchmark yield dropped 9 basis points to approximately 4.02% on Thursday, while the 30-year yield fell nearly 4 basis points to 5.15%.

Despite retreating from recent highs, both yields remain at their highest levels since at least 2011, indicating that the rate environment remains tight.

Over the past several weeks, municipal bond yields surged rapidly, largely in sync with the violent swings in the US Treasury market.

Rising Treasury yields pushed up the pricing benchmark for municipal bonds and further depressed the prices of existing bonds.

Ryan Ciavarelli, Senior Vice President of Credit Research at Belle Haven Investments, said that after the rapid yield increase in September, the municipal bond market rebounded this week with inflows into ETFs driving prices higher, also providing issuers with opportunities to complete financing as market conditions improved.

Selling pressure eases, higher yields boost allocation appeal

The return of ETF inflows suggests that after September's sharp correction, some investors are beginning to refocus on municipal bonds.

Yields rising to multi-year highs also allow new money entering the market to capture higher coupon returns, prompting some asset management institutions to highlight the allocation value of municipal bonds.

But the short-term rebound does not mean interest rate risk has dissipated.

Sustained high yields will push up financing costs for state and local governments on one hand, and on the other hand mean that existing bond prices remain vulnerable to interest rate fluctuations.

Future market performance will continue to depend on inflation trends and the Federal Reserve's policy path.

As long as inflation pressures and the risk of further rate hikes persist, the municipal bond market will struggle to fully shake off the pressure of rising rates; if rates stabilize, current higher yields could further attract allocation capital.