This compared favorably with -0.39% returns in investment grade, 1.51% in high yield tax-exempt, and 0.10% returns in taxable, respectively, during the same period.5,6,7 The outperformance in the municipal market comes despite issuance being up 33% as of the end of February on a year-on-year basis, thanks to the return of mutual fund inflows.8
Poised for continued strength
We expect mixed performance in the muni market to continue into the second quarter. However, the previously persistent outflows in mutual funds that have plagued the market over the last two years seem to have turned around. Nevertheless, the increase in Treasury rates along with heavy supply has been a bit of a headwind. We expect high yield bonds to continue to outperform as issuance in this segment of the market remains light and fundamentals remain relatively strong across sectors.
We believe credit spreads, particularly in the BBB investment-grade and BB high yield camp, may still have room to run in Q2. A potential rally in interest rates may accelerate that tightening in spreads as investors chase absolute yield. High yield still demonstrates historical value relative to its corporate counterparts where investors pick up an average of 103 basis points (bps) in tax-equivalent yield by investing in high yield munis over its corporate high yield equivalent, this compares favorably to its 62 bps three-year historical average.
The belly may go hungry
From a duration perspective, we believe a barbell approach would be best suited for income-driven investors. The muni yield curve is inverted in the 3- to 7-year part of the curve (Chart 1). This inversion is why investors should be wary of investing in that piece of the curve (the belly). As the curve normalizes and steepens, that belly is vulnerable to underperformance. It offers less relative value than the shorter and longer points of the curve and may be exposed to underperformance in the event of renormalization of the yield curve.
If inflows continue from mutual fund buyers, we expect the profile of those buyers to have a greater appetite for the absolute yields that are found in the short and longer end of the municipal yield curve which may accelerate the normalization process once through the April tax time.
Chart 1. AAA muni curve remains inverted in the 3- to 7-year portion
Sectors to watch in Q2
Housing
We have a constructive view on housing as demand shows continued signs of strength across the country. From a fundamental standpoint, we have seen the sector benefit from a track record of stable cash flows as well as a slowing of prepayment risk.
In addition, over-collateralization of the asset class remains robust as valuations remain high. When we look at spreads relative to their peer group, we also see relative attractiveness in the spread pick up in both investment grade and high yield segments, where investors can pick up 85 and 8 bps over its like quality counterparts (Charts 2 and 3).
Chart 2. Investment-grade housing spread to AA municipal bonds
Chart 3. High yield housing spread to high yield municipal bond index
Education
Another sector we are bullish on is that of charter schools, we believe that from a fundamental perspective, the sector has continued to demonstrate value across the country. We are particularly attracted to schools that offer a program of academic outperformance relative to its local peer group as those schools tend to see continued growth both in terms of enrollments and the number of schools within its obligated group.
The size of the charter school network can offer investors a diversification of geographic risk as well as a realization of some administrative cost savings through economies of scale. The sector continues to grow its share of the primary education market in the public sector, and we believe as that happens and investors become more comfortable with the operating model, spreads will continue to compress over the long term.
Healthcare
Finally, we think healthcare, particularly hospitals, offers an attractive opportunity at this point in the cycle. From a revenue perspective, hospitals have rebounded from the pandemic lows in terms of delivery of higher-margin elective procedures, which has contributed to a stabilization in revenues.
On the cost side of the equation, staffing pressures have eased as issuers are less reliant on temporary labor to supplement their workforce. In addition, we have seen merger and acquisition activity begin to pick up in this area, which may contribute to margin expansion as economies of scale are realized for the larger providers across the country.
Taxables
We also like the taxable municipal market as a potential acceleration in redemptions of Build America Bonds5 has provided and may continue to provide a tailwind for a segment of the market that is starved for supply. From a historical perspective, taxable municipal yields indeed look tight relative to the investment-grade corporate market but given the lack of supply projected in the taxable municipal market and the relative credit quality and yield pickup, we believe a case can be made for spread compression in this sector of the market to continue in the near future.
Final thoughts
We believe munis present attractive relative value when compared to its corporate counterparts to begin the second quarter. As we look ahead, we believe technicals in the market are trending in a positive direction and fundamentals remain relatively strong in the asset class, providing a favorable backdrop for investors with an active approach to investing in the market.
1 Bloomberg US Corporate Bond Index, March 2024.
2 Bloomberg U.S. Aggregate Index, March 2024.
3 Bloomberg U.S. Corporate High Yield Bond Index, March 2024.
4 Bloomberg U.S. Treasury Index, March 2024.
5 Bloomberg Municipal Bond Index, March 2024.
6 Bloomberg Municipal Bond: High Yield (non-Investment Grade), March 2024.
7 Bloomberg Municipal Index Taxable Bonds, March 2024.
8 JPM Research, March 2024.
9 Build America Bonds, part of the American Recovery and Reinvestment Act (2009), were taxable municipal bonds that featured federal tax credits or subsidies for bondholders or state and local government bond issuers.
Important information
Past performance is not an indication of future results.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Standard & Poor’s credit ratings are expressed as letter grades that range from 'AAA' to 'D' to communicate the agency’s opinion of relative level of credit risk. 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. The investment grade category is a rating from 'AAA' to 'BBB-'.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.
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