Five Key Themes for Today’s Municipal Bond Market

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The past few years have been eventful ones for the municipal bond market. Following the low-rate environment coming out of the pandemic, munis suffered one of their worst periods in history in 2022, from both a performance and demand perspective. The market rebounded somewhat in 2023, with respectable performance and strengthening demand, particularly in Separately Managed Accounts.

In 2024, we’ve seen a continuation of that recovery, but there has been an important change in the market environment: After a series of rate hikes that began in March 2022, the U.S. Federal Reserve (Fed) cut interest rates in September—and the trend is largely expected to continue over the near term.

As we enter the final quarter of 2024, we will explore the opportunities in today’s municipal market and highlight key themes we believe are important for municipal bond investors.

1. Year-to-Date Supply Is Near Record Highs

The municipal market has experienced a significant uptick in issuance this year, with tax-exempt supply reaching the highest levels in several years. In the first three quarters of 2024, total issuance was approximately $380 billion (based on data from SIFMA), growing over 40% from the same period in 2023 and 20% higher than the five-year average.

An increase was largely expected after two consecutive years of constrained issuance, continued infrastructure and capital spending needs, and an end to the historic federal stimulus related to the onset of COVID-19. Adding to this, uncertainty around the 2024 presidential election has led issuers to pull forward new issues, so we believe the pace of this year’s record-setting supply may moderate after the election. Additionally, November and December have historically brought technical tailwinds for the market, given the sizable reinvestment capital that returns to the market at the end of the year. Therefore, we think the fourth quarter may present an attractive entry point for investors as the technical landscape potentially becomes more supportive.

2. Municipals Offer Attractive Value

With a moderation in the U.S. labor market and a cooling of price pressures, Treasury yields have adjusted lower over the past few months. But given the supply / demand dynamics in municipals, muni rates have not rallied to the same extent. Since Treasury yields peaked in late April, the yield on the 10-year U.S. Treasury note has declined by almost 50 basis points (bps), while the yield on AAA-rated municipal bonds is only about 15 bps lower than its 2024 peak.

Figure 1. Municipal Bonds Remain Attractively Valued versus Treasuries

Yield (Treasuries) and tax-equivalent yield (municipals), Dec. 29, 2023–October 25, 2024

Source: MMD. AAA GO = AAA-rated general obligation municipal bonds. Tax-equivalent yield assumes the top marginal tax bracket of 40.8%, which includes the 37.0% income tax rate and the 3.8% in Medicare tax. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

While municipal yields are just off their recent highs, they remain elevated relative to much of the last decade, and attractive versus taxable fixed-income sectors. Furthermore, history has shown that as you move further into a period when the Fed is reducing interest rates, municipal bonds have generated strong absolute performance. With municipal yields across all maturities higher than at the start of the year and the curve continuing to show significant steepness, we believe investors may find this an opportune time to participate in the muni market as we enter the early stages of the Fed cutting cycle.

Figure 2. Municipal Bonds Have Performed Well After Fed Rate Cuts

Average total return following the first rate cut in the last seven U.S. Federal Reserve rate-cut cycles since 1984

Source: Bloomberg and Lord Abbett. Bloomberg U.S. Aggregate = Bloomberg U.S. Aggregate Bond Index. Municipals = Bloomberg Municipal Bond Index. 3-Month T-Bills = U.S. Treasury bills. Data represent the average performance of the indicated indexes and securities over the 6-month, and 1-year periods following the first federal funds rate cut in the previous seven cycles by the U.S. Federal Reserve. Start dates of the seven periods are 10/2/84, 10/19/87, 6/5/89, 7/6/95, 1/3/01, 9/18/07, and 7/31/19.
The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is no guarantee of future results.

3. Inflows Are Strengthening

During the difficult market environment in 2022, municipal bond funds experienced record outflows with approximately $115 billion leaving the category between January 2022 and October 2023. (All fund-flow data cited here are from LSEG Lipper.) Inflows were slow to return despite municipals offering the highest yields in over a decade. Now, as investors anticipate additional rate cuts by the Fed, flows are starting to turn.

Since the start of the year, the market has experienced roughly $32 billion in inflows. This number alone leaves something to be desired, especially compared to the inflow cycle of 2021. But when looking closer, over half of 2024’s total inflow has been realized since the end of June. In fact, the market has experienced 17 consecutive weeks of inflows so far in the second half of the year, with the weekly flow averaging close to $1 billion per week, much higher than weekly positive flows earlier in the year.

Figure 3. Muni-Bond Fund Flows: Reversal in Sentiment May Present a Tailwind for the Market

Monthly inflows/outflows for municipal bond mutual funds, August 2014–August 2024

Source: Morningstar and Bloomberg. Monthly mutual fund flows represented by Morningstar Municipal Bond Categories. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is no guarantee of future results.

These data point strongly toward the long-awaited rebound in mutual fund flows. This is consistent with other periods in which the Fed has cut interest rates, as research from J.P. Morgan shows that the last six such periods led to significant stretches of inflows.

A continued resurgence in mutual fund flows may have significant implications for the market, namely in lending support to lower-rated, investment-grade municipals, high yield munis, corporate-backed bonds, and longer-duration bonds. Long-duration muni bonds have historically experienced significant demand as the market transitions into easing cycles. An increase in flows to funds focused on the longer end of the curve could serve as the catalyst for the much-anticipated rally in longer muni rates.

4. Market Fundamentals Remain Sound

While it’s important to understand the technical environment, looking at fundamentals, municipal credit remains on sound footing. As of the end of the second quarter, state and local tax revenues grew over 7% compared to the previous year; compared to the five-year average, tax receipts were almost 18% higher.

Figure 4. State and Local Government Revenue Growth Remains Steady

Annual tax revenue from state and local governments, Q1 2014–Q2 2024

Source: U.S. Census Bureau. For illustrative purposes only.

In terms of ratings actions, August marked the 38th consecutive month that upgrades outpaced downgrades, according to S&P Global. Over the last 12 months, the upgrade/downgrade ratio was greater than 3-to-1.

High yield municipal credit fundamentals also remain sound. Municipal defaults have historically been rare and isolated to certain market segments, and so far in 2024, they remain below historical averages, suggesting a stable credit backdrop. More importantly, we are not seeing any significant uptick in indications of credit deterioration, such as dwindling reserves or issuers requesting covenant leniency—factors that historically have hinted at upcoming distress.

5. Opportunities in Muni Tax-Loss Harvesting

Given the current elevated level of yields, along with supportive credit fundamentals and technical factors, we believe this is a good time for investors to consider municipal bonds. As we head into the final quarter of the year, we also think it is important for investors to review their existing portfolios to see if there are opportunities for tax-loss harvesting. While municipals have had positive returns over the past year, there may be positions still trading at a loss due to the bond market volatility of 2022. Tax-loss trading can turn those losses into an asset, offsetting gains in other parts of the portfolio to reduce overall tax bills, while repositioning portfolios to take advantage of today’s market. Rather than waiting for year-end, when liquidity may be limited as we approach the holiday season, we suggest looking for opportunities for tax harvesting throughout the year.

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About the Author

Nicholas Bragdon

Product Specialist

Nicholas Bragdon is a Product Specialist responsible for covering Lord Abbett’s High Quality Fixed Income and Municipal strategies. In this role, he is responsible for developing investment narratives, marketing materials, and strategic plans for our products across retail and institutional channels.

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Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

A basis point is one one-hundredth of a percentage point.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

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