Municipal bond deals: Let’s make a yield

Bottom line up top:

• Earnings season wrapping up. With 93% of companies having  reported third-quarter financial results, the S&P 500 Index is set to  complete its fifth consecutive quarter of earnings growth. But even  though 75% of those reporting have exceeded estimates for earnings  per share (EPS) growth, the magnitude of outperformance has been  disappointing, bringing to mind the classic quip, “Earnings beat  expectations, but not by as much as expected.” Index-level earnings  growth for Q3 currently sits near 5.4%, roughly 200 basis points  below the pace that analysts had estimated at the end of the second  quarter, according to FactSet. In fact, only three of the S&P 500’s 11  sectors have delivered earnings growth higher than their 30 June  projections (Figure 1). And though U.S. equities appear to be settling  after a powerful post-election rally, rapid price appreciation paired with  decelerating earnings growth has led to frothy valuations: The S&P 500  is trading at 22.2x its 12-month forward price to earnings (P/E) ratio —  a 20% premium over its 5-year average of 18.1x
• Portfolio positioning for the post-post-election world. Barring  a meaningful pullback during the last six weeks of 2024, extended S&P  500 valuations are unlikely to prevent the index from gaining at least  20% for the fifth time in eight years. Dominant mega cap technology  stocks, which propelled much of the index’s rise in prior years, have  seen their influence wane in favor of broader sector participation and  leadership during the 2024 rally. This broadening has coincided most  notably with the significant shift in interest rate expectations in July  and the outcome of the November election. Market expectations for  deregulation and pro-growth fiscal policies fueled outperformance by areas like the financials sector (especially banks) and small cap stocks,  which jumped +7% and +11%, respectively, in early November. Meanwhile,  though U.S. equities could realize further upside heading into early 2025,  we recognize that some of the anticipated policy changes — namely, tax  cuts, deficit spending and tariffs  — have the potential to reignite inflation  and keep Federal Reserve policy rates higher than previously forecast for  this easing cycle. Such a backdrop supports portfolio allocations to asset  classes that can serve as a hedge against inflation and/or may benefit  from a higher-for-longer interest rate environment. 

Portfolio considerations

In the wake of the U.S. presidential election, municipal bonds remain one  of our favorite asset classes. The prospect of expanded stimulative measures  from the incoming administration, coupled with a potentially less dovish Fed,  could result in higher-for-longer U.S. Treasury and municipal yields, thereby  offering muni investors higher levels of income over a more extended period  than previously anticipated. Meanwhile, state and local government coffers  are flush with record levels of cash as tax collections — the main source of  repayment for municipal bonds — continue to increase.

Healthy economic data since the September rate cut, the first of the Fed’s  new easing cycle, has caused the Treasury curve to steepen, with the 10 year yield up by more than +60 bps. Even with that steepening, the overall  Treasury curve is still a nearly flat line (Figure 2). In contrast, both the  investment grade and high yield municipal curves show investors being rewarded for extending duration. The highest-quality municipals (AAA  rated) are outyielding Treasuries across the curve, with the differential  growing larger as maturities increase. High yield municipals have a longer  duration than their investment grade counterparts and were yielding 5.4%  as of 14 November, with a taxable-equivalent yield of 9.1% for investors in  the top income tax bracket.

In the investment grade muni space, airports are one of our highest conviction segments. Air passenger volume continues to fly high and is  projected to rise +10% this year versus last, to a new record level. We also  like water/sewage providers, as these essential service monopolies benefit  from ample liquidity and cash from federal COVID relief programs.

As for high yield munis, health care continues to stabilize after facing  post-COVID challenges, with operating margins beginning to recover  as expenses normalize. Among health care municipal issuers, we favor  large systems with sizable balance sheets and strong market positions. In  addition to health care, municipal land-secured deals look attractive amid  still-robust housing demand and diminished selling due to high mortgage  rates, which pushes buyers into new housing communities and supports  sector credit quality.

Nuveen’s Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.

Regular meetings of the GIC lead to published outlooks that offer:

• macro and asset class views that gain consensus among our investors
• insights from thematic “deep dive” discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
• guidance on how to turn our insights into action via regular commentary and communications