The taxable municipal bond market experienced negative third quarter returns in sympathy with U.S. Treasuries. With the U.S. Federal Reserve (Fed) nearing the end of its rate hike cycle, higher yields have increased future expected returns, given yields are now at levels not seen over the last decade. We believe portfolios should be rewarded by assuming a modestly longer duration profile while adding credit risk.
Key takeaways
- The surge in Treasury yields contributed to negative taxable municipal market performance for the quarter.
- The Fed’s higher-for-longer stance provides the most attractive entry point for taxable municipal investors in more than a decade.
- A positively sloped taxable municipal credit spread curve and strong fundamentals provide an opportunity to drive income.
Outlook
Clip the coupon through near-term uncertainty
We see several main factors driving fourth quarter taxable municipal bond performance. Most important is the surge in U.S. Treasury yields that has not been supported by fundamentals. Ultimately, we think softening inflation should lead to a more range-bound interest rate environment, and technical shocks may offer attractive entry points for investors willing to absorb near-term volatility.
Second, taxable municipal market technical factors continue to be buoyed by strong demand and slower issuance.
Further, municipal credit fundamentals remain strong. Plentiful reserves mean municipalities are generally well positioned to weather an economic slowdown driven by higher interest rates. Despite this, credit selection continues to grow in importance as tighter economic conditions pressure specific names.
Finally, the Fed has affirmed its commitment to defeating inflation. 30-year Treasury real yields are their highest in the last decade, and a positively sloped municipal yield curve and strong fundamentals provide an opportunity to drive income. After a painful 2022 and challenges in 2023, income investors assuming the Fed would have paused already in 2023 have not experienced the price returns they expected. But higher yields have increased future expected returns.
Going forward, income investors do not require declining yields to have a positive experience. With Treasury market stabilization, taxable municipal bond investors may enjoy more than 5.5% annualized returns through income alone for high quality, essential service investments.
Economic environment
- Inflation has come down sharply in recent months, and the trajectory is favorable due to goods and the rollover of housing costs.
- Core services inflation excluding housing remains sticky and elevated.
- The fed funds rate has risen by 525 bps during this cycle. Federal Reserve policy remains data dependent, with a focus on core services inflation.
- Another rate hike is possible before year-end; we do not expect rate cuts until the second half of 2024.
- U.S. growth should trend lower as the impact of Fed policy is fully absorbed. Key factors include interest rates, continued headwinds in the banking sector and declining money supply.
- While the economic slowdown may be milder than expected, we remain unconvinced the Fed can engineer a soft landing.
- Uncertainty regarding the end of Fed rate tightening continues to cause elevated rates. Anticipate a return to range bound trading once the Fed is done with rate hike campaign.
Municipal market environment
- Credit remains strong, with historic levels of rainy day funds.
- While revenue collections are solid and above 2021 levels, they have slipped below the peaks witnessed in 2022.
- We expect municipal defaults will remain low, rare and idiosyncratic.
- Supply should return in the fourth quarter but remains depressed compared to the prior year.
- Demand through the third quarter has focused on intermediate, long duration and high yield.
- Absolute yields are now at levels last seen in 2007, which might spur investor demand heading into 2024, particularly when investors have conviction the Fed is done hiking.
- Municipal performance is expected to rebound as interest rates stabilize and inflows return.