Taxable municipal bonds: building momentum

In the first quarter, the taxable municipal bond market displayed relative strength in the face of rising Treasury yields. The U.S. economy remains strong, and municipal credit fundamentals are benefiting from a resilient consumer and strong labor market. Limited new issue supply and strong demand for high quality, long duration assets led to relative outperformance for taxable municipal bonds. We believe demand could strengthen as investors consider shifting to longer duration municipals ahead of U.S. Federal Reserve (Fed) rate cuts.

Key takeaways

• Higher income generation and credit spread narrowing helped taxable municipal bonds absorb an increase in long-term Treasury yields.
• Investors recognize that lengthening duration may benefit portfolios in the short-term should yields move lower.
• The taxable municipal bond market enters the second quarter with relative strength, supported by above average yields and positive technical and fundamental factors.

Outlook

2024 STARTS OFF RIGHT

The municipal bond market started in a great place to begin 2024.

Yields began 2024 at their highest levels since 2011, thanks to aggressive Fed policy and a strong economy. Investors may enjoy attractive total returns from income alone, a dynamic absent for nearly a decade.

Real yields, a bond’s stated yield minus inflation rate, sit at the highest levels since 2009. While inflation has been moderating, it remains considerably less than the current short-term fed funds rate of 5.25%.

We expect Fed cuts to begin in the second half of 2024. Such an environment has historically steepened the yield curve. A steepening yield curve should be positive for longer-duration bonds, allowing investors to receive the higher income associated with longer-dated bonds while earning additional total return through a combination of declining rates and rolling down the curve. The municipal market continues to await a trigger to accelerate fund flows, and Fed cuts might be that catalyst.

A supply/demand disparity should keep yields and spreads contained, as expected net negative supply would create scarcity among a shrinking pool of outstanding bonds. Declining rates may result in additional supply later in 2024, but consecutive years of low supply should allow for any uptick in supply to be readily absorbed. 2024 should create a unique dynamic with the U.S. presidential election causing some supply to move forward with issuers attempting to issue bonds before the election.

Municipal credit is in a strong position to weather potential economic uncertainty. Statutory reserves remain very high, despite excess reserves being drawn down. Though the economy remains on strong footing, we expect taxable municipals to perform well if markets move to a risk-off tone due to their resilience during past economic downturns. In recent years, credit upgrades have outpaced downgrades by a factor of 4:1. Taxable municipal bonds remain well placed to capitalize on solid credit fundamentals, and option-adjusted spreads could tighten further, providing total return potential.

Economic environment

•  Inflation trajectory remains favorable 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 in 2024 with the timing dependent on inflation, wages and employment data.
• U.S. growth has been resilient and recession risks have declined. Key factors include employment data, consumer spending and levels of excess household savings. Capital markets are leaning towards a ‘no landing’ scenario, but recession risks remain.
• Uncertainty regarding the beginning of Fed rate cuts and balance sheet contraction 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.
• While revenue collections are below peaks witnessed in 2022, they remain above pre pandemic levels.
• We expect municipal defaults will remain low, rare and idiosyncratic.
• Taxable supply has remained suppressed to start the year but could be more robust in the months leading up to the election.
• Demand has favored owning duration with U.S. municipal mutual fund inflows favoring the long-end of the curve.
• As yields remain higher-for-longer, investor demand has begun to return due to prevailing market sentiment of anticipated Fed rate cuts.
• Municipals have displayed strong relative performance to begin the year.
• Taxable municipal credit spreads have tightened but remain attractive relative to other credit markets.
• Absent a meaningful rate rally or spread contraction, municipals can still post attractive returns based on elevated income generation.