Municipal Fixed Income: Shelter From The Storm?

Origami dollar seedling being watered with coins — Richard Drury

By James L. Iselin

Technical factors and market volatility are creating a value opportunity in the U.S. municipal market. Today’s CIO Weekly Perspectives comes from guest contributor James L. Iselin, Head of Municipal Fixed Income.

The summer months are typically a quieter, more predictable time in the municipal fixed income market, as supply tends to be modest and demand rises due to higher levels of bond reinvestment. This summer has been anything but quiet, however, as volatility on the political and economic fronts, and rapidly evolving views on Federal Reserve policy, have caused swings in interest rates. Specific to the muni market, perhaps the biggest surprise this year has been new issue supply that is running well ahead of expectations, up roughly 40% from last year. More importantly, supply has not moderated during the summer. We think this increased summer issuance is likely the result of deals getting pulled forward, as issuers may be cautious about coming to market later in the fall ahead of what is likely to be an uncertain U.S. political climate. With markets wide open and demand solid, municipal issuers are jumping at the opportunity to price deals.

Heavy issuance, which really began to accelerate in May, has caused municipal valuations to meaningfully soften relative to the first four months of the year. When comparing 10-year AAA muni yields to those of Treasuries on a percentage basis, they currently stand at roughly 70% versus 60% earlier this year. In a higher-yield environment, today’s ratios could cause munis to deliver a decided yield advantage to U.S. taxpayers. For example, intermediate investment grade munis currently yield around 3%, a major improvement from 0.67% at the start of 2022. Tax-adjusted for a U.S. taxpayer in the highest bracket, today’s yield would be 5.07% or 119 basis points over intermediate Treasuries. In fixed income investing, especially when taxes come into play, we believe that what matters isn’t the yield you are getting, but rather the yield you are keeping.

While municipal credit quality has already peaked, it is entering this period of moderating economic growth from a position of strength. An economy growing at a 1.5 – 2% clip still creates a decent backdrop for municipal credit quality, in our view. In addition, many state and local governments are sitting on near-record reserves as a result of strong economic growth in recent years and substantial federal aid during the pandemic. In our view, there is no major sector of the market or any large issuer that is currently showing meaningful signs of stress, so we believe the likelihood of a shock to the market is remote. Finally, fund flows, which were a huge headwind for the muni market in 2022 and 2023, have moved decidedly positive in 2024. Investors like today’s yields, the market’s high credit quality, and the likelihood that the Fed’s next move will be to start lowering rates.

As investors transition from summer to fall, market volatility may rise as focus intensifies on monetary policy, geopolitics, and the U.S. election. In our view, high-quality municipal bonds offer a compelling place to be in uncertain times. Within this market, we think investors should also consider extending duration and getting out of cash so they can keep today’s yields for longer. Given that valuations are already attractive, if volatility rises or continued heavy supply causes the municipal market to cheapen further, we will view it as an even more compelling buying opportunity. Credit quality is strong, tax-adjusted yields are favorable, and elevated supply should likely create opportunities to quickly deploy cash and find mispriced opportunities. Munis should prove to be a “safe port” if the weather gets a little stormier.

What to Watch For

- Monday, August 26:
  - U.S. Durable Goods Orders (Preliminary)
- Tuesday, August 27:
  - S&P Case-Shiller Home Price Index
  - U.S. Consumer Confidence
- Thursday, August 29:
  - U.S. Q2 GDP (Second Preliminary)
- Friday, August 30:
  - Eurozone Consumer Price Index (Flash)
  - U.S. Personal Income & Outlays

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