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Agribusiness

Municipal market: Bonds are acting like bonds again

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2023 saw continued market volatility as investors assessed the impact of U.S. Federal Reserve rate increases. With the Fed signaling the end to rate hikes and possible cuts, investors can focus on municipal bonds behaving like bonds again: offering tax-exempt income and providing portfolio diversification.

Longer duration is coming into favor

The Fed appears to be finished raising interest rates, with the median of the dot plot of individual expectations indicating cuts of 100 basis points (bps) in 2024 and a total of 300 bps longer term. Such an environment has historically steepened the yield curve.

A steepening yield curve should be positive for longer-duration bonds, allowing investors to receive higher income associated with longer-duration bonds while earning additional total return through a combination of declining rates and rolling down the curve.

Figure 1: By extending duration, investors may achieve higher tax-efficient yields

Short-term yields will not last

The conclusion of the hiking cycle likely means the end for these attractive short-term yields. Bond yields have historically fallen by about 1 percentage point on average in the year following the last Fed rate hike, and rates have already declined from their recent peak on 31 Oct 2023.

Figure 2: Yields have fallen quickly when the Fed stops hiking
The conclusion of the hiking cycle likely means the end for these attractive short-term yields.

Municipal bonds offer attractive yields

Aggressive Fed policy and a strong economy have boosted market yields to the highest levels in more than a decade. This means investors may maximize income at more attractive rates than in previous years.

Municipal bonds also offer an attractive taxable-equivalent yield (TEY) opportunity, as the interest earned is exempt from regular federal taxation and in some cases state and local taxes. For investors residing in high-tax locations such as California, New York State and New York City, TEY will be even more attractive.

Figure 3: Muni yields are attractive vs. other broad fixed income sectors

Real yields are positive

Real yields — a bond’s stated yield minus the inflation rate — sit at the highest levels since 2009. While inflation remains above central bank targets, it has moderated significantly. Real yields should remain attractive as central banks maintain higher interest rates while inflation continues to decline. Municipal bond yields started 2024 at their highest level since 2011. In this environment, investors may enjoy attractive total returns from income alone, a dynamic absent for almost 10 years. Municipals do not need a meaningful rate rally or dramatic spread compression to offer outsized, equity-like returns.

Figure 4: Municipal bond yields exceed inflation
In this environment, investors may enjoy attractive total returns from income alone, a dynamic absent for almost 10 years.

Technical imbalances favor munis

Municipal bond gross supply is expected to total $350 billion to $450 billion in 2024, up slightly from $330 billion in 2023. However, with approximately $400 billion of bonds maturing in 2024, supply will likely be net negative. Demand should exceed supply, as proceeds from matured bonds will require investments in new bonds. And declining rates may result in other bonds being called early, with these additional reinvestment needs further increasing demand.

This supply/demand disparity should keep yields and spreads contained, as net negative supply creates scarcity among a shrinking pool of outstanding bonds.

Figure 5: Gross municipal bond supply is expected to be higher in 2024

Municipal bond fundamentals are strong

Municipal credit is in a strong position to weather potential economic uncertainty. State and local governments have high cash balances, and we expect munis to perform well in a risk-off environment due to their resilience during past economic downturns. In recent years, credit upgrades have outpaced downgrades by a factor of 4:1.

Municipal bonds should be well placed to capitalize on these solid fundamentals, and we think spreads can tighten further and provide total return potential.

Figure 6: Muni credit spreads have been stable, reflecting supportive fundamentals

2024 municipal bond market outlook

We believe the municipal market is poised for improvement in 2024. The Fed’s anticipated easing this year should bolster demand for municipal bonds. If investor sentiment shifts positively, as we expect, strengthening demand could absorb secondary market supply and act as a catalyst for spread tightening. We see favorable conditions for municipal bonds, with attractive yields to start the year and solid credit fundamentals for state and local governments. In this environment, we think municipal bonds have attractive potential in diversified, long-term portfolios.

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Endnotes

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. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

Nuveen, LLC provides investment solutions through its investment specialists.

This information does not constitute investment research as defined under MiFID.

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