Municipals Finish Strong Despite Market Volatility
Investment-grade (IG) and high-yield municipal (HYM) bonds capped off an otherwise interesting year of performance fluctuations and policy uncertainty to cross the finish line with fanfare. A rate rally during the year’s final two months that saw municipal yields decline by about 100 basis points (bps) propelled quarterly and annual performance comfortably into positive territory, with longer-duration bonds nearly touching double-digit returns.
Chart 1: Absolute Yields of Municipal Bond Indices Remain Attractive
Source: Bloomberg, as of December 29, 2023.
Indexes are unmanaged and do not reflect a deduction for fees or expenses. Investors cannot invest directly in an index. Information is subject to change and is not a guarantee of future results.
IG and HYM bonds closed the books with 6.4% and 9.2% gains, respectively, per Bloomberg, besting U.S. treasuries, which delivered 4.05%. Across fixed income assets, municipals, on a tax-adjusted basis, were one of the best performers of the year. The sharp reversal of fortunes for municipals in 2023 was a welcome reward following disappointment in 2022. As we look ahead, municipal investors should continue to benefit from the current momentum but cannot rule out the occasional “breather” in price support. Fed actions will garner attention as the market broadly anticipates potential rate cuts during 2H2024. At the same time, the impact on municipal bonds should result in sufficient investor demand and positive, albeit somewhat muted, returns this year.
Concerning the value opportunity of municipal bonds, although the market experienced an appreciable decline in yields recently, their absolute levels remain at multiyear highs, continuing to offer long-term investors an entry point to capture attractive tax-efficient income. According to Bloomberg, taxable-equivalent yields on the IG and HYM indices were 5.4% and 9.4%, respectively, as of year-end. The relative strength of municipal cash flows should be compelling for investors, as the benefits of coupon accrual over time typically account for a higher proportionate share of total return (i.e., compounding of income), thus providing a cushion against price volatility and/or implications of an economic slowdown or perhaps even recession. Accompanying absolute yields is the shape of the municipal curve, with the slope between 10- and 30-year bonds at about 115 bps (as of year-end), the steepest since 2014. With valuations fully priced on earlier maturities, potential outperformance could be earned by selectively investing in intermediate-long bonds that may further benefit from easing Fed policy. In the coming months, as municipal market-specific considerations come into focus, coupled with economic conditions, geopolitics, and monetary policy, curve placement will become increasingly important for investors to potentially generate portfolio alpha.
The technical landscape has been mixed throughout 2023 as municipal bond fund outflows persisted most of the year, while gross supply declined slightly (about 3% year over year). In the year ahead, a more consistent pattern of inflows into municipal bond funds could be accretive to asset class performance as clarity surrounding Fed policy becomes evident. Moreover, issuance likely ticks higher as lower rates improve deal volume. However, prudent municipal budgeting and evolving election dynamics could temper the willingness of issuers to access the market. We expect credit risk to remain manageable as most sector issuers have either met or exceeded their pre-pandemic operations while strengthening their balance sheets. The wide margin of rating agency upgrades-to-downgrades is expected to normalize as the economy decelerates, but the ratio should remain positive. While borrowers in many high-yield sectors exhibit stability, pressure on certain healthcare and higher education enterprises continues. We expect resilient municipal bond credit quality this year, and we will continue to monitor budget management strategies as the cycle shifts.
Chart 2: Various 2023 Municipal Index Returns
Source: Bloomberg, as of December 29, 2023.
All indices used in the chart above are Bloomberg.
Past performance or performance based upon assumptions is no guarantee of future results. Indexes are unmanaged and do not reflect a deduction for fees or expenses. Investors cannot invest directly in an index. Information is subject to change and is not a guarantee of future results.
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