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November 2023

Tax-Exempt Strategies: As Munis Tiptoe Into Year-End, Yields Are Becoming Hard to Ignore

Key Points

  • Rising rates pressure performance but set up long-term investors.
  • Valuations are improving as curve inversion diminishes.
  • Credit spreads are buoyed by delayed expectations for economic softening.

Municipal bonds seemingly ran the gauntlet during the third quarter as the Fed remains steadfast in its mission to achieve its dual mandate while embracing a “higher for longer” bias, per the dot plot. Elevated volatility resulted in 10-year benchmark municipal bond yields rising about 90 bps, compared to 73 bps in comparable Treasuries, leading to underperformance. According to Bloomberg, investment grade (IG) and high yield (HYM) municipal bond returns flipped red through the year’s first nine months. However, the price pressure has markedly improved buying opportunities in municipal bonds. For example, the yield-to-worst (YTW) on IG and HYM bond Bloomberg indices increased by approximately 80 bps (to 4.4%, or 7.25% tax-adjusted) and 55 bps (to 6.25%, or 10.5% tax-adjusted), respectively, during the quarter, settling nominal yields at their cyclical highs and well-positioning investors with a longer-term horizon to lock in attractive tax-efficient income streams. 

Chart 1: Municipal Index YTW Reach Cyclical Highs

Source: Bloomberg, as of September 30, 2023

Indexes are unmanaged and do not reflect a deduction for fees or expenses. Investors cannot invest directly in an index.


The municipal bond yield curve’s upward shift improved the relative value versus comparable Treasuries. The 10- and 30-year AAA municipal/Treasury ratios increased to 75% (from 67%) and 92% (from 90%) during the quarter, suggesting the tax benefit of owning municipal bonds is more valuable to an investor. The shape of the yield curve is notably less inverted, further signaling the current attractiveness of municipal bonds. From a technical perspective, the summer is typically a seasonally demand-driven period of the year as maturities and redemptions exceed issuance. Gross supply is down nearly 15% YoY, partly attributable to the fiscal strength of state and local governments (SLGs) and the cost of borrowing and carrying charges on new money and refunding issuance. While issuance is likely to pick up during 4Q2023, based on previous patterns, continued unpredictability and volatility in the market are likely to temper any meaningful supply. The outflows within municipal bond mutual funds have yet to reverse YTD, but retail and strategic asset managers continue to take advantage of the generational yields available. Once additional clarity is achieved in regards to the end of the rate cycle and Treasuries stabilize within a narrower range, municipal bond demand from institutional accounts should return.  

The gradual compression of credit spreads is an interesting dynamic in both IG and HYM bonds. Estimates for economic growth to stall and potentially experience a recession did not occur as widely expected. Despite an aggressive Fed, the economy has exhibited resiliency, which has benefitted the fundamental quality of municipal bond issuers. SLGs enjoyed back-to-back double-digit fiscal performance during FYs 2021 and 2022. Many issuers closed the books in FY 2023 in a position of strength as reserves sit near record highs. YTD troubled borrower statistics in HYM are low, per Municipal Market Analytics, but with isolated stress seen within senior living and rural hospital sectors. Nevertheless, the overall quality of municipal bonds is favorable, but we will continue to monitor issuers’ plans for guarding against a slowdown in the economy.  


Chart 2: AAA Benchmark Municipal Yields Increased Sharply During 3Q2023

Source: Bloomberg, as of September 30, 2023

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.


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