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Municipal Bonds

Taxable Municipal bonds: yields moving higher

Daniel J. Close
Head of Municipals
Kristen M. DeJong
Portfolio Manager
Andrew J. Luberto
Client Portfolio Manager
4Q taxable municipal bonds commentary

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

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
Municipal market environment

Full report

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