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Fixed income

Taxable municipal bonds: building momentum

Daniel J. Close
Head of Municipals
Kristen M. DeJong
Portfolio Manager
Philip C. Traven
Portfolio Manager
An airplane taking off from an airport runway

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

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
Municipal market environment

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