Taxable municipal bonds: prepared for a rally

Taxable municipal bond market returns finished slightly negative during the second quarter. Low new issue supply and improving demand narrowed spreads, but volatile U.S. Treasury yields weighed on performance. Nevertheless, taxable municipals have gained positive momentum, offering an attractive entry point to investors.

Key takeaways

• Taxable municipal bond yields increased, but income generation has protected investors against interest rate volatility.
• New issuance remains suppressed, providing a technical tailwind supporting performance as higher yields bolster investor demand.
• We believe portfolios should be rewarded by assuming a modestly longer duration profile while adding credit risk.

Outlook

Higher yields are driving returns

We see several factors driving third quarter performance. First, taxable municipals should continue to be buoyed by strengthening demand alongside ample coupon and reinvestment dollars, in tandem with slower issuance. While issuance is likely to increase compared to the first half, we do not anticipate it will outpace demand. Higher borrowing costs and record reserves should keep borrowing needs muted.

Second, inflation appears to be normalizing and should provide more stability for investors. As clarity emerges regarding the end of U.S. Federal Reserve (Fed) rate hikes, investors look toward the taxable municipal market’s attractive valuations to add duration while providing additional income.

Credit fundamentals remain strong due to historic revenue collections in the wake of the pandemic. While municipal revenue collection has peaked from post-covid highs, strong reserves make municipal bonds well positioned to weather an economic slowdown driven by higher interest rates. Despite this, we believe credit selection will continue to grow in importance as tighter economic conditions put pressure on specific names.

Finally, the positively sloped taxable municipal credit spread curve and strong fundamentals should provide a positive investment experience for intermediate to long-term credit during the third quarter and beyond. After a painful 2022 and a volatile yet positive start to the year, we expect bond activity to return to historic norms for the remainder of the year, underpinned by income and strong balance sheets.

We believe our bottom-up, fundamental credit research process is well-positioned to take advantage of the opportunities we are seeing in the market today.

Economic environment

• Inflation has come down sharply in recent months, and the trajectory is favorable due to lower energy prices, housing costs and rents.
• However, core services inflation excluding housing remains sticky and elevated. The fed funds rate has risen by 500 basis points (bps) during this cycle.
• Fed policy remains dependent on employment and inflation data.
• We do not expect rate cuts for the balance of 2023 as the Fed contends with elevated core services inflation.
• U.S. growth should trend lower as the impact of Fed policy is absorbed. Key factors include interest rate hikes, headwinds in the banking sector and declining money supply.
• Recession is a concern, though the timing continues to be pushed.
• Uncertainty regarding the end of Fed rate tightening continues to cause rate volatility. Anticipate a return to range-bound trading once stable conditions return.

Municipal market environment

• We expect municipal defaults will remain low, rare and idiosyncratic.
• Credit remains strong, with historic levels of rainy day funds.
• Revenue collections are expected to normalize from covid peaks, but remain solid.
• Supply remains muted due to higher interest rates. Benign taxable municipal supply will likely persist through the summer, providing technical support.
• Demand is returning for taxable municipals due to higher yields and high credit quality.
• Municipal performance is expected to improve as interest rates stabilize, and investor demand strengthens.
• Absent a meaningful catalyst, municipals can still post attractive returns based on elevated income generation from adjusted rates.
• Long-term taxable municipal valuations are attractive on a spread basis, compared to similar maturity U.S. Treasuries and corporate bonds.