Muni Outlook: Focus on the Big Picture

December 7, 2023 Cooper Howard
We see potential opportunity in municipal bonds in 2024, although there may be more volatility.

For 2024, we believe that municipal bonds will be an area of potential opportunity for high-income earners. However, those investors would be well-served by taking a step back and focusing on the big picture and not getting spooked by the myriad issues that may arise. We expect 2024 to be characterized by bouts of volatility as a result of the likely Federal Reserve shifting from tightening to easing, a likely slowdown in the economy and inflation, and the U.S. presidential election casting questions over tax policy and other fiscal issues.

Despite the potential for a rocky road, we would not be surprised if the broad municipal bond market delivered positive total returns in 2024. Longer-term investors can benefit, in our view, from taking advantage of today's high interest rates before they move lower due to the Fed likely shifting to easier policy. We expect credit quality to remain resilient, but issuers may face headwinds as tax revenues slow and the financial support provided after the onset of the COVID-19 pandemic winds down. As a result, we suggest staying up in credit quality and adding to lower-rated investment grade issuers, like A/A and BBB/Baa rated issuers,1 cautiously. Lower-rated issuers tend to have less-stable revenue streams and lower reserves, and their credit ratings may be more susceptible to an economic slowdown.

Here are some of the key trends we think investors should be aware of:

1. Absolute rates are high now, but we expect them to move lower in 2024. There are two main reasons why we believe munis are an area of potential opportunity in 2024:  high yields and strong credit quality. To illustrate, the yield-to-worst for the Bloomberg Municipal Bond Index, a broad based index, is 3.7%. Although it has pulled back recently, it's still near the highest level since 2011.

Yields are at the highest point since 2011

Chart shows the yield to worst for the Bloomberg Municipal Bond Index dating back to August 2001. It was 3.6% as of December 6, 2023, near the highest level since 2011.

Source: Bloomberg Municipal Bond Index, weekly data as of 12/6/2023.

Past performance is no guarantee of future results.

Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.

Granted, 3.7% is below the yield on other fixed income investments of similar credit quality and maturities, but it's because munis are generally exempt from federal and potentially state income taxes. One method to compare the yield on a tax-exempt municipal bond to a fully taxable bond is to analyze the tax-equivalent yield. The tax-equivalent yield is the yield assuming the muni were subject to federal, state, and other applicable taxes. As of the end of November, the tax-equivalent yield for the broad index was around 7% for an investor in the top tax bracket, which we believe is attractive relative to alternatives of similar credit quality.

Municipal bond yields are relatively attractive after considering the impact of taxes

Bar chart shows the yields for various fixed income instruments as of December 5, 2023. The municipal bond tax-equivalent yield for an investor paying a 50.8% tax rate was 7.1%, and for an investor paying a 29% tax rate was 4.9%. This is higher than other instruments, including Treasuries.

Source: Bloomberg, as of 12/5/2023.

Past performance is no guarantee of future results.

The 50.8% tax rate assumes a 37% Federal tax, 3.8% ACA tax, and 10% state tax. The 29% tax assumes a 24% tax rate and 5% state tax rate. HY Corporates = Bloomberg US Corporate High Yield Index; EM USD Bonds = Bloomberg EM USD Aggregate Index; TEY Municipal Bonds (50.8% tax rate) = Bloomberg Municipal Bond Index Yield To Worst; Preferreds =  ICE BofA Fixed Rate Preferred Securities Index; IG Corporates = Bloomberg US Agg Corporate Yield To Worst; MBS = Bloomberg US MBS Index Yield To Worst; U.S. Aggregate = Bloomberg US Agg Yield To Worst; TEY Municipal Bonds (29% tax rate) = Bloomberg Municipal Bond Index Yield To Worst; Treasuries = Bloomberg US Agg Treasury Yield To Worst; Municipal Bonds = Bloomberg Municipal Bond Index. 

Although absolute yields are elevated now, we expect them to decline in 2024, which would  help boost total returns. In our view, inflation should abate and growth should slow, which will likely pull down longer-term yields. The implication is that although yields have pulled back recently, we believe that muni investors should consider adding some longer-term bonds.

Additionally, longer-term municipal bonds offer greater relative value compared to shorter-term munis in our view. The gap between AAA-rated municipal bonds and Treasury bonds after-taxes is fairly tight up until about 10-years and then begins to widen out. We don't advocate investing in very long-term bonds but the implication is that for investors looking to round out their muni holdings and add duration, longer-term munis offer greater value than short-term munis in our view.

The other implication is that investors who are not in the top federal tax bracket, but are looking for very highly rated investments, may be able to achieve a higher after-tax yield with certificates of deposit or Treasuries, compared with AAA-rated municipal bonds.

Longer-term munis are attractive relative to Treasuries after taxes

Chart shows the yield for AAA rated munis, Treasuries, and Treasuries after taxes at maturities ranging from 1 to 30 years, as of December 5, 2023.

Source: Bloomberg, as of 12/5/2023.

Past performance is no guarantee of future results.

AAA munis are represented by the Bloomberg AAA BVAL (Bloomberg Valuation Service). Treasuries after-taxes assumes a total tax rate of 40.8%.

2. Supply and demand dynamics should bode well for total returns in 2024. If we're correct in our view that longer-term rates have likely peaked for this cycle and will decline in 2024, we would not be surprised if demand picks up for munis. That may seem counterintuitive because higher rates are more attractive and should therefore attract more demand, but we've found that when yields decline, demand starts to pick up because returns are positive. One proxy for demand that we track is fund flows to mutual funds and exchange-traded funds (ETFs). Fund flows are loosely correlated with total returns for municipal bonds. In other words, shortly after yields decline and prices move higher (because yields and prices move in opposite directions), demand begins to pick up in the form of positive fund flows. Favorable demand without a parallel uptick in supply should further support total returns in 2024.

3. Credit conditions are strong, but issuers may face headwinds in 2024. The other primary reason that we believe munis will be an area of opportunity in 2024 is because credit quality is strong. Although credit quality is strong now, headwinds are likely to emerge in 2024. However, we expect that most issuers will be in a position to adequately manage through those headwinds.

Municipal bonds on average are highly rated to begin with, but since the pandemic the average credit rating has increased. For example, prior to the pandemic, 67% of the bonds in the Bloomberg U.S. Municipal Bond Index were rated either Aaa or Aa, which are the top two rungs of investment grade. As of November 30, that has improved to 71.4%. Aside from October 2023, when it was slightly higher, that's the highest proportion of Aaa or Aa rated bonds in the index since late 2008.

The share of highly rated bonds has increased in a key index

Chart shows the percentage of securities in the Bloomberg U.S. Municipal Bond Index that are rated Aaa or Aa dating back to December 2008. As of November 30, 2023, the percentage was at its highest level since 2008.

Source: Composition of the Bloomberg U.S. Municipal Bond Index, as of 11/30/2023 using monthly data.

4. Tax revenues are slowing and may slow more. State tax revenues have experienced substantial growth since the onset of the pandemic, but are starting to moderate. We would not be surprised if tax revenues continue to slow, assuming our expectation that the economy will slow in 2024 takes hold. In that case, tax revenues would likely slow, which would be a headwind for states. However, we do not anticipate this would result in serious credit deterioration for most states, because many have used the combination of strong tax revenue growth and fiscal support since the onset of COVID-19 to build up their rainy-day and reserve balances.

A rainy-day fund is akin to a savings account that a state can tap into, with some restrictions, if there's a decline in revenues or they need to balance their budget. According to The Pew Charitable Trusts, prior to the pandemic states could operate from their rainy-day funds alone for approximately one month, on average. This has improved since then to approximately a month and a half. Narrowing in, all but 12 states experienced an increase in their rainy-day fund balance from fiscal year 2020 to fiscal year 2023.

The chart below shows the change in the number of days that each state could run on their rainy day fund alone from fiscal year 2020 to fiscal year 2023. The yellow dot is the value for fiscal year 2020, the blue dot is the value for fiscal year 2023, and the red or green bars are the change from FY2020 to FY2023. In most instances states experienced a large increase in their rainy-day funds, as evidenced by the number of green bars. For example, in fiscal year 2020, Nevada, at the top of the chart, lacked a rainy-day fund balance. That has since improved by about 30 days. The decline in Washington's rainy day fund balance is mostly due to how Pew defines a rainy-day fund, not an actual large decline in the state's fiscal situation.

Most states have experienced an increase in their rainy-day fund balance

Chart shows the change in the balances of state rainy-day funds from fiscal year 2020 to fiscal year 2023.

Source: The Pew Charitable Trusts, as of 11/28/2022, which is the most recent data available.

Chart excludes the top five states with the largest rainy-day funds [North Dakota (from 112.2 days to 107.7 days), Nebraska (from 34.6 days to 120.2 days), New Mexico (from 119.6 days to 157.9 days), Alaska (from 104.8 days to 181.9 days), and Wyoming (from 353.8 days to 376.8 days)] for visual purposes. For illustrative purposes only.

5. Buckle up for what's likely to be a wild election season. Another source of volatility for municipal bonds in 2024 likely will be the election. It's difficult to handicap this as a risk because what is said on the campaign trail versus what, if anything, actually comes to fruition will likely be wildly different. We would not be surprised if there is debate over the future of the 2017 Tax Cuts and Jobs Act, which is set to sunset in 2025. Among other things, it altered the tax brackets and reduced the value of some itemized tax deductions while increasing the size of the standard deduction. Yields for municipal bonds adjusted to the tax changes by generally moving lower relative to taxable alternatives like corporates and Treasuries. Additionally, demand for municipal bonds in high-tax states like New York or California tightened as high-income earners sought out the tax benefits that municipal bonds may offer. Although they're not set to sunset until 2025, talk of them being altered could be a source of volatility.

Summing it all up

Municipal bonds currently offer yields that mostly haven't been available for the past 15 years, but we don't expect that to last. We look for 2024 to be favorable for muni returns, but it will be characterized by bouts of volatility as the market navigates myriad potential risks and headwinds. Given the potential for rates to move lower and the economy to slow, we favor staying up in quality and adding to lower-rated issuers selectively. We would be cautious on issuers that have revenue streams that are closely tied to economic activity and do not have strong reserves.

1 The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.

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