Core Equity: Q4 2023
Tax-Exempt Strategies:
Municipals Finish Strong Despite Market Volatility
Key Points
- Higher rates bring bilateral focus to the market
- Investment opportunities surface amid volatility
- Emphasis on issuer and sector selectivity
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.
Important Information
The views expressed represent the opinions of City National Rochdale, LLC (CNR) which are subject to change and are not intended as a forecast or guarantee of future results. Stated information is provided for informational purposes only, and should not be perceived as personalized investment, financial, legal or tax advice or a recommendation for any security. It is derived from proprietary and non-proprietary sources which have not been independently verified for accuracy or completeness. While CNR believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations,estimates, projections, and other forward-looking statements are based on available information and management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions which may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Diversification may not protect against market risk or loss. Past performance is no guarantee of future performance.
There are inherent risks with equity investing. These risks include, but are not limited to stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junkbond. When interest rates rise, bond prices fall.
Bloomberg risk is the weighted average risk of total volatilities for all portfolio holdings. Total Volatility per holding in Bloomberg is ex-ante (predicted) volatility that is based on the Bloomberg factor model.
Municipal securities. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in the municipal securities of a particular state or territory may be subject to the risk that changes in the economic conditions of that state or territory will negatively impact performance. These events may include severe financial difficulties and continued budget deficits, economic or political policy changes, tax base erosion, state constitutional limits on tax increases and changes in the credit ratings.
Index Definitions
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization weighted index that is designed to measure developed equity market results, excluding the US and Canada.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization weighted index that is designed to measure equity market results in the global emerging markets, consisting of more than 20 emerging market country indexes.
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the US It is not an exact list of the top 500 US companies by market cap because there are other criteria that the index includes.
Bloomberg Barclays US Aggregate Bond Index (LBUSTRUU): The Bloomberg Aggregate Bond Index or “the Agg” is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
GT10: US Government Treasury Yield
Bloomberg Municipal Bond Index: The Bloomberg US Municipal Bond Index measures the performance of investment grade, US dollar-denominated, long-term tax-exempt bonds.
Bloomberg Municipal High Yield Bond Index: The Bloomberg Municipal High Yield Bond Index measures the performance of non-investment grade, US dollar-denominated, and non-rated, tax-exempt bonds.
S&P Leveraged Loan Indexes (S&P LL indexes) are capitalization-weighted syndicated loan indexes based upon market weightings, spreads and interest payments. The S&P/LSTA Leveraged Loan 100 Index (LL100) dates back to 2002 and is a daily tradable index for the US market that seeks to mirror the market-weighted performance of the largest institutional leveraged loans, as determined by criteria. Its ticker on Bloomberg is SPBDLLB.
Bloomberg US Corporate Bond Index: The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Bloomberg US High Yield Index: The Bloomberg US Corporate High Yield Index measures the performance of non-investment grade, US dollar-denominated, fixed-rate, taxable corporate bonds.
Bloomberg: LF98TRUU Index: The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded. This is the total return index level.
Morningstar SPBDLLY Index: Yield to maturity time series of the Morningstar LSTA US Leveraged Loan 100 Index. The Morningstar LSTA US Leveraged Loan Index is a market-value weighted index designed to measure the performance of the US leveraged loan market.
Bloomberg Investment Grade Index: The Bloomberg US Investment Grade Corporate Bond Index measures the performance of investment grade, corporate, fixed-rate bonds with maturities of one year or more.
Bloomberg Municipal Bond Index: measures the performance of investment grade, US dollar denominated, long term tax exempt bonds.
Bloomberg US Treasury Index: includes all publicly issued, U.S. Treasury securities that are rated investment grade, and have $250 million or more of outstanding face value.
Investment Grade (IG) Municipal Bond Index: The Bloomberg US Municipal Bond Index measures the performance of investment grade, US dollar-denominated, long-term tax-exempt bonds.
High Yield (HY) Municipal Bond Index: The Bloomberg Municipal High Yield Bond Index measures the performance of non-investment grade, US dollar-denominated, and non-rated, tax-exempt bonds.
Definitions
Yield to Worst (YTW) is the lower of the yield to maturity or the yield to call. It is essentially the lowest potential rate of return for a bond, excluding delinquency or default.
P/E Ratio: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS).
City National Rochdale Proprietary Quality Ranking formula: 40% Dupont Quality (return on equity adjusted by debt levels), 15% Earnings Stability (volatility of earnings), 15% Revenue Stability (volatility of revenue), 15% Cash Earnings Quality (cash flow vs. net income of company) 15% Balance Sheet Quality (fundamental strength of balance sheet).
*Source: City National Rochdale proprietary ranking system utilizing MSCI and FactSet data. **Rank is a percentile ranking approach whereby 100 is the highest possible score and 1 is the lowest. The City National Rochdale Core compares the weighted average holdings of the strategy to the companies in the S&P 500 on a sector basis. As of September 30, 2022. City National Rochdale proprietary ranking system utilizing MSCI and FactSet data.
Non-deposit investment Products are: • not FDIC insured • not Bank guaranteed • may lose value
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