31 Oct 2024
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Municipal Bonds
Taxable municipal bonds: bouncing back
The U.S. Treasury yield curve flattened during the fourth quarter with yields increasing across the curve, reflecting continued stubborn inflation and shifting U.S. Federal Reserve (Fed) policy expectations. Taxable municipal bonds underperformed corporate bonds and Treasury bonds due to their long duration stance in a rising rate environment. With favorable near-term valuations, taxable municipal bonds should see improved performance through a more range bound Treasury market environment. This environment makes current valuations an attractive entry point for long-term investors.
Key takeaways
- Taxable municipals exhibited negative absolute performance as U.S. Treasury yields increased, but the fundamental credit story remains intact, supporting long-term investment.
- Municipal balance sheets remain well positioned; however, active management is important to avoid potential impacts from idiosyncratic credit events.
- Following Fed interest rate cuts during 2024, and the yield curve to steepen further, investors should explore extending duration.
- With credit spreads across various asset classes near all-time tights, Build America Bonds offer attractive up-in-quality trade while gaining additional yield.
Outlook
Seasonal strength should support municipals
The taxable municipal bond market is well positioned to begin the first quarter.
Supply remains suppressed amid persistently high interest rates, with advanced refunding volume remaining muted compared to 2020 and 2021 levels. While supply remains benign, the elevated pace of maturities, calls and coupons in January may provide additional technical support. Throughout 2025, we expect a net negative supply environment for taxable municipal bonds.
Credit spreads remain relatively attractive, with A rated municipal bonds at 77 basis points (bps) option adjusted spread. While credit markets have broadly tightened in response to a robust economy and strong appetite for yield, the taxable municipal market continues to offer greater spread relative to corporate bonds for equally-rated bonds.
The credit spread curve continues favoring investors through absolute yield and relative value. Despite interest rate policy expectations meaningful shift in the final quarter of 2024, the taxable municipal spread curve continues to provide value for investors looking to increase duration and yield. The steepness of the taxable municipal spread curve out to 12-year duration rewards investors with higher income than typically associated with longer-dated bonds, and potential to earn additional total return through a combination of stable or declining rates and credit spread narrowing through the holding period. However, active yield curve management is important, as duration longer than 12 years sees diminished benefits and requires careful selection.
2025 Themes
Economic environment
- The Fed expects the lower inflation trend of 2024 to continue, with inflation working toward 2.5% in 2025.
- The Fed cut rates aggressively by 100 bps in the latter half of 2024. Rate cuts should continue as long as inflation moves toward the target.
- U.S. growth remains resilient. We will be watching unemployment data, consumer spending and excess household savings.
- Capital markets anticipate low risk of recession, but we continue to monitor developments closely.
- Federal policy, along with the timing and magnitude of future rate cuts, could trigger yield volatility.
Municipal market environment
- Credit remains strong, with robust revenue collections and reserve funds.
- State governments are adjusting for normalization of revenue collections.
- Municipal defaults are expected to remain low, rare and idiosyncratic.
- We anticipate another year of heavy new issue supply in 2025, approaching $500 billion. Taxable muni supply has become more muted in the elevated rate environment, making up roughly 10% of the overall municipal market.
- Demand for owning duration continues, driven by higher-for-longer yields.
- Attractive valuations relative to other credit markets will continue to garner demand.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Performance data shown represents past performance and does not predict or guarantee future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.
Important information on risk
Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments. This information should not replace an investor’s consultation with a financial professional regarding their tax situation.
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