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The municipal bond (muni) market has experienced a resurgence in recent years.

Driven by factors such as strong investor demand, attractive relative value, and the potential impact of sunsetting the Tax Cuts and Jobs Act.1 Which is why, we believe, issuers must recognize when munis are having a moment.

A tailwind for munis

The muni market has benefited from robust investor demand, which we believe has been fueled by several factors:

  • The tax-exempt nature of muni income has become increasingly attractive as some state income tax rates have risen.
  • Elevated yields are offering an historically attractive opportunity for investors to lock in high income for a longer period.

Strong demand has supported muni prices, leading to compressed yield spreads relative to taxable bonds. While this may limit immediate yield opportunities, we believe it also suggests a relatively stable market environment. Additionally, the demand for munis and upcoming election fears have contributed to increased issuance – up 40% relative to last year – providing investors with a broader range of investment options.2

Relative value + interest rate expectations

Another important consideration is the relative value of munis compared to other fixed income asset classes. While muni yield spreads have compressed, we believe munis still offer investors attractive after-tax returns. Moreover, the sector's lower volatility and higher credit quality compared to other fixed income asset classes can be appealing in uncertain market conditions.

With strong credit fundamentals and the first rate cut behind us, munis – a best-kept secret for the majority of 2024 – may be a secret no longer.

Investor perceptions of the interest rate cycle also influence muni valuations. As interest rates rise, bond prices typically fall, including munis. However, with strong credit fundamentals and the US Federal Reserve’s (Fed) first rate cut behind us, munis – a best-kept secret for the majority of 2024 – may be a secret no longer.3

Potential window of opportunity

Investor sentiment has slightly improved in the first six months of 2024 (Chart 1).

Chart 1. Tax-exempt municipal bonds’ absolute yields (2019 vs. Present)

We believe that there could be several reasons why investors are hesitant to take advantage of the current strong municipal credit outlook and attractive yields. This hesitation may be due to significant developments over the past two years, including the Fed’s rate increases to fight inflation ("higher-for-longer"), the Russia-Ukraine War, regional banking stress, conflict in the Middle East, and uncertainty surrounding the upcoming US presidential election in November.

The impact of the Tax Cuts and Jobs Act1

The Tax Cuts and Jobs Act introduced several provisions that affected municipalities and muni investors.1 While these provisions are scheduled to sunset at the end of 2025, we believe a potential extension or expiration will have significant implications for issuers and investors.

If the Tax Cuts and Jobs Act provisions are extended, municipalities may face increased fiscal challenges due to reduced federal revenue sharing.1 This could lead to higher borrowing costs and potentially lower credit quality for some issuers. Conversely, if the provisions expire, it could result in increased tax burdens for individuals and corporations, potentially boosting demand for tax-exempt munis.

Final thoughts

At this point the Fed has started its Fed pivot, we expect this to result in increased interest across all fixed assets. Once the rush for fixed income begins, we expect investor funds will quickly return to the municipal market, potentially reaching the levels of enthusiasm seen in 2019, 2020, and 2021. If this scenario unfolds, it will become progressively challenging to find suitable bonds to include in fixed income portfolios, hence the need to start allocating early.

Article adapted from Jon’s recent appearance on the Public Money Pod podcast episode “Relative Value in Municipal Bonds and their Issuers,” produced by the University of Chicago’s Center for Municipal Finance.

1 The Tax Cuts and Jobs Act was signed into law on January 1, 2018. This law brought sweeping changes to the tax code and impacted individuals depending on their income level, filing status, and deductions.
2 "Investors Suddenly Have a Lot More Active Muni ETFs to Choose From." Morningstar, Aug 2024. https://www.morningstar.com/funds/investors-suddenly-have-lot-more-active-muni-etfs-choose.
3 "Tax-Exempt Municipal Bonds Could Be 2024’s Best-Kept Secret (But Not for Long), Mid-Year 2024 Update." HilltopSecurities, July 2024. https://www.hilltopsecurities.com/insight/tax-exempt-municipal-bonds-could-be-2024s-best-kept-secret-but-not-for-long-mid-year-2024-update/.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Indexes are unmanaged and have been provided for illustrative purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

High yield securities may face additional risks, including economic growth; inflation; liquidity; supply; and externally generated shocks.

AA-170924-183132-1

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