Taxable municipal bonds: Long term opportunities persist

Positive returns in May and June brought taxable municipal performance close to breaking even (-0.19%) for the second quarter, following a challenging April. The power of income has offset weaker months, and the combination of price appreciation and income has resulted in strong relative performance. Taxable municipals have been supported by technical factors and strong credit fundamentals. We believe demand for municipals could strengthen as investors consider shifting to longer duration ahead of anticipated U.S. Federal Reserve (Fed) rate cuts.

Key takeaways

• The power of higher income generation helped taxable municipal bonds absorb fluctuating, upwardly biased U.S. Treasury yields.
• The taxable municipal bond market remains supported by above-average yields, strong fundamentals and an improving technical backdrop.
• For certain investors, we believe there is a unique, compelling opportunity currently present in Build America Bonds.

Outlook

Technical tailwinds should support the market in Q3

The taxable municipal bond market is well positioned to begin the third quarter.

Supply showed signs of increasing during the second quarter. Taxable municipal supply is approximately $19.5 billion year-to-date, on track to outpace the 2023 total of $35 billion. Issuers brought deals that had been long delayed due to execution uncertainty and sought to avoid volatility that may accompany the U.S. election. Despite the lumpier issuance calendar, meaningful coupon payments and bond maturities provided a natural buyer for the elevated supply.

July and August are showing signs of further technical strengthening through organic demand created by reinvestment from maturing bonds. According to Bloomberg, $6.1 billion in taxable municipal bonds outstanding will mature during July and August. This reinvestment, coupled with historically light new issuance, could shift technical factors favorably.

We anticipate positive technical conditions for municipals later this year, as continued reinvestment income combines with expected slower issuance. Taxable municipals could be further assisted by an expected Fed rate cut in the fourth quarter, which may drive inflows as investors seek to lock in yields.

2024 themes

Economic environment

• Inflation trajectory has trended lower year-over-year. The Fed projects marginally lower Core PCE Inflation by year-end. Core services inflation excluding housing remains sticky but is trending down.
• After increasing the fed funds rate by 525 bps during this cycle, the Fed has been on hold since July 2023. Fed policy remains data dependent. We expect rate cuts, with the timing dependent on inflation, wages and employment data.
• U.S. growth has been resilient, but the consumer is softening. Influential factors include unemployment data, consumer spending and levels of excess household savings. Capital markets are at less risk of recession, but we continue to monitor developments closely.
• Uncertainty regarding Fed policy will continue to cause rate volatility. Rates could decline if a slowdown or recession develops.

Municipal market environment

• Credit remains strong, with robust levels of rainy day and reserve funds. Governments are adjusting for normalization of revenue collections..
• We expect municipal defaults will remain low, rare and idiosyncratic.
• Supply has picked up relative to 2023 levels and could be more predominant before the U.S. election. The largest sectors for new issuance have been single family housing and general obligation.
• Attractive Build America Bonds (BABs) spreads over non-BABs provide an opportunity for some investors to enhance yield.
• Demand favors owning duration, driven by higher-for longer yields. Investors don’t want to miss out.
• Municipals have displayed strong relative performance this year.
• Absent a meaningful rate rally or spread contraction, municipals should generate attractive returns based on elevated income generation.