Municipal Bonds: Five Key Themes for Today’s Market

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After one of the worst bond markets in history in 2022, municipal bonds generated respectable returns in 2023. However, almost all the positive performance for the year was realized in November’s rally and December’s policy pivot by the U.S. Federal Reserve. From the vantage point of early 2024, it appears that the market has not fully recovered from the 2022 repricing and many opportunities remain.

Below are the five themes we believe will drive performance in the year to come.

1. Credit Fundamentals Will Likely Remain Strong

Coming out of the pandemic, enormous federal spending and a better-than-expected economic recovery led to unparalleled fundamental strength in the municipal market. It has been estimated that approximately $1 trillion was passed down to state and local governments and other municipal entities as a result of pandemic relief spending. Keep in mind, the total outstanding debt in the municipal bond market is $4 trillion. This led to municipal tax receipts and state government “rainy-day” balances growing at record levels in 2021, and then again in 2022.

We expect that the fundamental backdrop will remain strong. While the record-setting growth in tax revenues and rainy-day balances has moderated over the last year, we believe that municipal credit is returning to a more normalized environment. Tax receipts are still significantly above levels experienced prior to the pandemic, and rainy-day balances relative to spending remain multiple times higher than during much of the last 15 years. With the decline in growth of tax receipts, we also anticipate spending by state and local governments will lessen, as many states move beyond the one-off expenditures of last year.

2. Curve Positioning, Credit Selection, and Bond Structure Will Drive Performance

While yields rallied to close 2023, the current market offers the opportunity to lock in yields not seen for much of the last decade, no matter where investors target on the curve. Looking closer, the historic inversion of portions of the front end calls for tactical adjustments and has allowed muni buyers to capture higher yields than the belly (middle) of the curve, with less rate risk. One effective way to access this anomaly is through so-called barbell strategies. Beyond the front end, the curve offers significant steepness from 12 to 17 years, which represents some of the best risk/reward and total return potentials in the market.

Keep in mind, longer-maturity municipal bonds have historically outperformed by a significant margin over the long term. Today makes for an attractive entry point in the long end, as the yield curve has steepened over the last six months, and long-dated municipal bonds remain one of the few areas of the fixed-income market where investors are being compensated to extend maturity. As of January 31, 2024, the municipal yield curve slope from two to 30 years is roughly 90 basis points (bps), compared to a flat slope over the same range in U.S. Treasuries, presenting a compelling opportunity for investors seeking to buy high-quality duration.

Finally, selecting the right bond structure will remain crucial, particularly if rate volatility continues. We believe investors should focus on bonds trading at deep discounts or premiums and avoid those trading close to their par value due to the inherent asymmetry of the risk and convexity dynamic, as bonds trading further outside par may perform better in market rallies. For similar reasons, we favor bonds with more call protection, allowing for full participation as the market continues to recover.

Figure 1. Muni Yield Curves Point to Opportunities in Short- and Longer-Dated Securities

Yield curves for indicated municipal-bond ratings categories and U.S. Treasuries, as of January 31, 2024

Source: LSEG Municipal Market Data. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. Tenor refers to the time to maturity of a debt issue. 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. Continued Recovery in Demand and the Return of Mutual Fund Inflows

In addition to being one of the worst years in terms of performance, 2022 also saw the most significant municipal bond outflow cycle in the history of the market. (See Figure 2.) There were also negative fund flows in 2023, but most of this pressure was driven by redemptions from short-term funds.

Figure 2. Muni-Bond Mutual Fund Flows Are in Recovery Mode

Weekly flows into municipal bond mutual funds, January 31, 2018–January 31, 2024

Source: LSEG Lipper. Data as of January 31, 2024. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a guarantee or indication of future results.

Looking more closely at last year, long-term funds experienced almost $10 billion in inflows, exchange-traded funds (ETFs) recorded positive net flows of over $11 billion, and municipal separately managed accounts (SMAs) continued to record strong demand.

After two years of rate volatility, many mutual fund managers have rebalanced positioning, and distribution yields have adjusted higher. And with potentially brighter prospects ahead, mutual funds are an attractive vehicle to participate in the market’s continued recovery. Given higher yields and assuming a lessening of rate volatility, we believe consistent municipal mutual fund inflows will resume in 2024.

We also believe SMAs will continue to be a valuable avenue to access the municipal market, particularly for investors who value customization, tax efficiency, and a strong client experience for their high-quality portfolios. However, more generic SMA structures that are restricted to bonds with maturities of 10 years or less, or that don’t offer access to credit-sensitive bonds, may not be as attractive as in years past, especially if the Fed cuts short-term rates.

4. Potential Outperformance of Higher-Yielding Sectors of the Market

Amid the outflow cycle over the last few years, certain segments of the market have underperformed due to technical, rather than fundamental, reasons, as portfolio managers accommodated client redemptions. Since the start of 2022, some of these parts of the market, such as corporate-backed and hospital bonds, bonds subject to the alternative minimum tax (AMT), BBB-rated and non-investment-grade credit tiers, and the long end of the muni yield curve, have generally lagged the broader market. Instead, more generic parts of the general obligation and utility sectors, high-quality investment-grade bonds, and the short end of the curve were among the market leaders.

The lower-rated and non-rated portions of the market currently show attractive value due to their strong fundamentals—2023 had very low default rates, and 2024 looks to be a similar story. Additionally, a strengthening of fund flows would certainly support some of these more volatile parts of the market, as was evident at points in time over 2023, as valuations remain compelling and have not yet recovered. We believe that as money starts to flow back to municipal mutual funds on a consistent basis, these higher-yielding segments may exhibit strong performance and potentially outperform as they have over the long term.

Figure 3. Higher-Yielding Segments of the Muni Market May Be Poised for Outperformance

Average return for indicated ratings categories and sectors, as of December 31, 2023

Source: Bloomberg. Data are for specific Bloomberg subindexes within the Bloomberg Municipal Bond Index (AAA, AA, BBB, General Obligation, Electric, 3-Year, 20-Year, Industrial Development Revenue [IDR], and Hospitals), and the Bloomberg High Yield Municipal Bond Index.

Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this table may not perform in a similar manner in the future. 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 expenses, and are not available for direct investment.

5. Variation in Lower-Quality Credit Performance

Going forward, we expect defaults to continue to be very low in the broader context of the market and isolated to certain sectors. While we continue to find attractive opportunities in high yield municipal bonds, security selection will be crucial, given the wide performance dispersion as lower-rated issuers adjust to slower growth.

Within high yield munis, we favor select corporate-backed issuers in the industrial development sector. Corporate borrowing costs have increased across capital structures, while companies continue to see impacts from input inflation. Despite these headwinds, corporate borrowers issuing in the municipal market tend to provide services in high demand or produce materials critical to infrastructure, energy procurement, and global stability. As a result, operations are generally stable across subsectors, and credit pressure, where it exists, is largely idiosyncratic.

Regarding hospitals, we expect acute care margins to improve as a rebound in volumes should drive revenue growth amid a continued deceleration in expenses. However, risks remain around Medicaid determination and some hospitals’ inability to control costs. Larger healthcare systems with a diversified geographic presence and strong market shares should fare better. While we believe hospital credit spreads present compelling opportunities in certain circumstances, there will be clear winners and losers over the next few years within the sector, so it will pay to be selective.

A Final Word

Municipal bonds’ high level of tax-free income, solid credit quality, and long-term return profile suggest that they should be a strategic allocation in investors’ non-qualified portfolios. Despite this, muni-bond mutual fund flows over recent years indicate that investors often make tactical decisions and overlook the potential long-term benefits of an allocation to munis. Considering the current market environment and the factors that may drive performance going forward, we believe the present time represents a compelling entry point into municipal bonds.

HYMAX

Class A

High Income Municipal Bond Fund

The Lord Abbett High Income Municipal Bond Fund seeks to deliver income exempt from federal income tax by investing in lower-rated municipal bonds.

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LANSX

Class A

National Tax Free Fund

The National Tax Free Fund seeks to deliver a high level of income exempt from federal taxation by investing primarily in investment grade municipal bonds.

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About the Contributors

Gregory M. Shuman, CFA

Partner, Portfolio Manager

Nicholas Bragdon

Product Specialist

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Glossary & Index Definitions

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.

In fixed income, a barbell strategy is constructed in such a way that half the portfolio contains long-term bonds and the other half holds short-term bonds.

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

Carry is the difference between the yield on a longer-maturity bond and the cost of borrowing.

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.

Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield-to-maturity (YTM) represents the expected return (expressed as an annualized rate) from the bond’s future cash flows, including coupon payments over the life of the bond and the bond’s principal value received at maturity. Yield-to-worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date.

The tax-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of the tax-exempt yield on a municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond to see which bond has a higher applicable yield.

The Bloomberg Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term, tax-exempt bond market. Bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two ratings agencies. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.

The Bloomberg General Obligation Municipal Bond is a category-specific subgroup of the Bloomberg Municipal Bond Index.

The Bloomberg Municipal Bond 3 Year Index is a maturity-specific component of the Bloomberg Municipal Bond index.

The Bloomberg High Yield Municipal Bond Index is an unmanaged index consisting of non-investment-grade, unrated or below Ba1 bonds.

The Bloomberg Long Current Coupon (22+ Years) Municipal Bond Index is a total return benchmark designed for long-term municipal assets. The index includes bonds with a minimum credit rating of BAA3, issued as part of a deal of at least $50 million, with an amount outstanding of at least $5 million and a maturity of 22 years or greater, with a dollar price of $96 to $104, and issued after December 31, 1990.

The Bloomberg U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade, fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Bloomberg Index Information: Source: Bloomberg Index Services Limited. BLOOMBERG^®is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material or guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, shall not have any liability or responsibility for injury or damages arising in connection therewith.

The Municipal Market Data (MMD) AAA Curve is a proprietary yield curve that provides the offer-side of “AAA” rated state general obligation bonds, as determined by the MMD analyst team. The “AAA” scale (MMD Scale), is published by Municipal Market Data every day at 3:00 p.m. Eastern standard time, with earlier indications of market movement provided throughout the trading day. The MMD AAA curve represents the MMD analyst team’s opinion of AAA valuation, based on institutional block size ($2 million+) market activity in both the primary and secondary municipal bond market. In the interest of transparency, MMD publishes extensive yield-curve assumptions relating to various structural criteria, which are used in filtering market information for the purpose of benchmark yield-curve creation.

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