Taxable municipal bonds: Starting strong
In the fourth quarter, the taxable municipal bond market posted its strongest quarterly return since 2011. Taxable municipals rallied in sympathy with U.S. Treasuries on expectations that the U.S. Federal Reserve (Fed) will begin easing rates in 2024. While rates have rallied from the highs, yields are at their highest point to start a year since 2011. We believe portfolios should be rewarded by assuming a modestly longer duration profile while selectively adding credit through essential service providers.
- The Fed’s dot plot in December suggested rate cuts in 2024, and the resulting Treasury rally supported the taxable municipal market in the fourth quarter.
- We believe attractive yield levels and the prospects of rate cuts should bolster demand for long-duration fixed income.
- Taxable municipal bonds should be well placed to capitalize on solid fundamentals.
Many reasons for confidence
We believe the taxable municipal market is poised for improvement in 2024, depending on how the economy responds to the end of Fed rate hikes. The Fed and others believe a soft landing is still possible, but we remain unconvinced. Regardless, we believe municipal credit may help stabilize investment portfolios.
While the Fed’s torrid pace of rate hikes has impacted taxable municipal bond yields, credit fundamentals remain strong. State and local governments remain flush with cash after several rounds of stimulus during the pandemic, and revenues remain well above pre-pandemic averages.
Taxable municipal bonds should be well placed to capitalize on these solid fundamentals, with yields starting 2024 at their highest level since 2011. In this environment, investors may enjoy attractive total returns from income alone, a dynamic absent for nearly a decade.
2023 was the second consecutive year of increased market volatility for municipals, keeping some investors out of the market as they wait for the end of the Fed’s hiking cycle. We believe attractive absolute yield levels should encourage demand once investors remaining on the sidelines feel confident the Fed’s rate hikes are done.
Total new issue supply ended 2023 down 2% compared to 2022, the second consecutive year of lower year-over-year supply. Taxable municipal supply was even more suppressed, ending the year down -31% compared to 2022 levels. If investor sentiment shifts positively, as we expect, strengthening demand could absorb secondary market supply and act as a further catalyst for spread tightening given the scarcity of new issue paper over the last two years.
With a focus on fundamental strength, we believe municipal bonds have attractive potential in well-diversified, long-term portfolios.
- Inflation has softened in recent months via goods and the rollover of housing costs, providing favorable trajectory entering 2024.
- Core services inflation excluding housing remains sticky but is starting to trend down.
- The fed funds rate has risen by 525 basis points (bps) during this cycle. Fed policy remains data dependent, with a focus on core services inflation.
- We expect 150 bps of rate cuts in 2024 with the timing dependent on inflation, wage and employment data.
- U.S. growth should trend lower as the impact of Fed policy is fully absorbed. Key factors include interest rates, geopolitical issues and declining money supply.
- While a soft landing remains possible, once the economy begins moving one direction, it tends to stay on that course absent outside forces.
- Uncertainty regarding the end of Fed policy will continue to cause rate volatility.
- Fed funds could decline more than anticipated if the economy slows more than forecast.
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.
- Supply throughout 2024 could hover near levels seen in 2023. Predictions include more coupons, calls and maturities than new issues.
- Demand has favored owning duration, a trend which could continue and even accelerate in 2024 with investors who don’t want to miss out.
- Yields remain attractive despite a strong rally in November. Demand could increase in 2024 as investors gain conviction that the Fed is done hiking.
- Municipal performance rebounded sharply in November. Absent a meaningful catalyst, municipals can still post attractive returns based on elevated income generation from adjusted rates.
- Long-term, tax-exempt and taxable municipal valuations are attractive on a spread basis, compared to similar-maturity U.S. Treasuries and corporate bonds.