2024 Municipal Bond Market Outlook: Midyear Update

In Brief

The fundamental backdrop for the municipal bond market remains strong.
Rising yields since the start of 2024 could mean a potentially attractive entry point for investors, particularly given the tax-free status of munis.
The muni yield curve continues to present opportunities, especially for those considering barbell strategies.

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Municipal bond performance during the first part of 2024 demonstrates the generally-but-not-always true maxim that “carry wins” in fixed income. Despite increasing yields, prompted by the recalibration of U.S. Federal Reserve (Fed) rate cut expectations and a pickup in municipal bond supply, the Bloomberg Municipal Bond Index has performed in line with the Bloomberg U.S. Aggregate Bond Index and outperformed U.S. Treasuries since the start of 2024. Keep in mind, this performance is before considering the tax-free income of munis, which would further enhance excess returns. The high yield segment of the municipal market has fared even better, supported by strong demand and a healthy fundamental backdrop. As we enter the second half of 2024, we remain optimistic on municipal bonds given the attractive level of yields, strong fundamentals, improving technicals, and are finding attractive opportunities within the municipal yield curve.

With the rise in rates since the start of the year, municipal yields are near the highest levels seen over the past 15 years. For perspective, long-maturity yields are similar to those seen a decade ago coming out of the taper tantrum in 2013; 10-year muni yields are comparable to 2011 during the Meredith Whitney scare; and short-term yields are in line with 2007 prior to the Great Financial Crisis. The income available in today’s environment presents an attractive total return opportunity for investors, even if the Fed doesn’t lower rates this year, and provides protection in the event rates continue to rise. Given the high levels of yields and the expectations for the Fed’s next policy move to be a cut, we believe there’s a strong probability that total returns will be positive by the close of 2024.

The yield curve itself is also providing opportunity. Similar to taxable markets, the short to intermediate portions of the muni curve have inverted, and the belly has flattened out over the last 18 months. However, beyond the 12-year maturity mark, the municipal curve exhibits considerable steepness—something not seen in other fixed-income sectors—and actually steepened last year while other markets were flattening. In intermediate strategies, we are currently utilizing a barbell structure, focusing on short-term bonds with elevated yields and lower duration, as well as bonds maturing beyond 12 years with call protection, given the attractive steepness. For investors interested in moving farther out the curve, today makes for an attractive entry point as long-dated municipal bonds remain one of the few areas of the fixed-income market where investors are being compensated to extend. The municipal yield curve slope from 15 to 30 years is over 60 basis points (bps), compared to roughly 5 bps over the same range in U.S. Treasuries. As with all tax-exempt yields, the difference is even greater when adjusted for the tax advantage (see Figure 1).

Figure 1. Municipal Yield Curve Offers an Attractive Opportunity

Tax-equivalent yield (%) as of May 29, 2024

Source: MMD Refinitiv. Data as of May 29, 2024. Tenor refers to the time to maturity of a debt issue. 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. GO=general obligation. 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.

The municipal market has experienced a significant uptick in issuance this year, with tax-exempt supply reaching levels not seen since 2007, as of the end of April. This marks a departure from the below-average supply over the last few years, a period when state and local governments benefited from federal stimulus funds and a better-than-expected recovery from the pandemic. Now issuers are reentering the market, often offering higher coupons with the rise in interest rates. However, high yield municipal issuance hasn’t seen the same surge, and this divergence has been another supporting factor for the non-investment-grade market. We anticipate overall elevated issuance to continue, particularly over the summer months, as issuers push forward capital needs prior to election season, but the market should continue to handle it well.

On the demand side, the market has responded with a continuation of strong flows into Separately Managed Accounts. Mutual fund flows have also been positive, although less robust, with most of the demand going into long-term and high yield funds. Looking forward, we expect fund flows to increase further from the historic outflow cycle of 2022, especially as the future path of Fed policy becomes clearer.

Municipal market fundamentals continue to show strength as we approach the second half of 2024. Tax revenues and reserves have moderated but remain well above pre-pandemic figures and not far from historic highs. We foresee tax revenue streams and rainy-day balances maintaining their strength throughout the rest of the year. In the high yield segment, despite small, isolated pockets of pressure, we are finding attractive opportunities. Although defaults historically have been rare, they have fallen compared to the same period last year. And it’s important to remember that municipal defaults tend to occur gradually, often signaled by dwindling reserve funds or issuers requesting covenant leniency, which hints at upcoming distress. Overall, we are not seeing a significant uptick in these indicators this year, suggesting a stable credit backdrop.

In terms of sectors, we favor corporate-backed issuers in the Industrial Development sector, many of which provide services in high demand or produce materials critical to infrastructure, energy procurement, and global trade. We have a positive view of the Transportation sector due to its ongoing volume recovery bolstered by strong economic growth and low unemployment, and the ability of many issuers to adjust rates against rising costs. While Health Care has been pressured over the last few years, we continue to find opportunity in parts of the sector, particularly in hospitals that have a diversified presence and strong market share.

Finally, we believe the upcoming U.S. presidential election will not cause any significant negative impacts to the municipal market. Considering the federal deficit, which is historically high and continuing on an upward trajectory, we anticipate that tax rates for individuals are likely to remain stable or may even increase, irrespective of the election’s outcome. Furthermore, there is a chance that corporate tax rates could see an increase, which would increase the relative value of municipals versus taxable bonds for bank and insurance company buyers.

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About the Contributors

Daniel S. Solender, CFA

Partner, Director of Tax Free Fixed Income

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.

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

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.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates.

The Federal Reserve (Fed) is the central bank of the United States. The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.

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.

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

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 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.

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

Bloomberg Index Information

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