So far, 2024 has been an interesting year for fixed income investors. The mixture of economic uncertainty along with the Fed’s new ‘higher for longer’ message has thrown many bond investors for a loop. But even amid all the uncertainty, some interesting trends and themes have begun to take shape. This is particularly true for investors in the municipal bond space.
Those trends could shape returns and portfolio position for the back half of the year and into next.
That’s the gist according to new research from Lord Abbett. The asset manager points to five different themes that could shape the muni market. And in those themes, investors have a chance to score some great yields and income.
Driving Performance
The normally staid and sleepy municipal bond market has spent the last two years or so whipsawing around. After inflation surge highs not seen since the 1980s, the Federal Reserve’s rate hikes hit the sector hard. For 2022, the sector featured double-digit losses after factoring in interest payments. For 2023, the return was better, with munis posting positive returns.
So far this year, the municipal bond sector has been roughly flat. Investors continued to be attracted to the sector. However, thanks to the sector’s longer durations, the current rise in yields along with the Fed’s ‘higher for longer’ message has crimped returns.
However, according to asset manager Lord Abbett, this environment of high yields, low capital appreciation, and uncertainty has created opportunities for investors. And in that, five distinct themes are starting to play out for the rest of the year and potentially into next. 1
Credit Fundamentals
For starters, investors worried about rising default rates due to dwindling credit fundamentals may be able to get a good night’s rest. That’s because states and local governments are still in a strong position to keep paying their bills.
After the pandemic, many states’ coffers were filled with stimulus and excess cash. This helped boost rainy day funds for many governments.
While revenues are expected to slip, the still filled rainy day funds as well as overall reductions to spending are expected to help keep default rates low. Moreover, the labor market remains robust. Income tax revenues are expected to stay strong as well.
Ultimately, Lord Abbett believes that muni investors will be alright and have nothing to fear.
It’s All About the Curve & Credit
Thanks to the Fed’s tinkering with interest rates, the municipal bond market is now offering some of the highest yields not seen in decades. This is particularly true when compared to U.S. Treasuries.
Looking at the slope of the yield curve of municipal bonds from two to 30 years, the difference is only about 90 basis points in difference. This compares to a flat Treasury curve over the same time period.
Source: Lord Abbett
According to Lord Abbett, this allows investors to take full advantage of yields across the duration spectrum. It’s in this yield curve that investors can find excess returns over other bond varieties throughout the year. Munis are priced for success.
Investors Are Finally Coming Back
With strong yields and still strong credit quality, investors have finally started to take notice. Asset classes’ current valuations are simply derived from supply and demand. Today, demand for munis is starting to come back.
After a huge outflow in 2022, long-term municipal bond funds saw positive inflows of $10 billion, while ETFs tracking munis saw inflows of $11 billion. This trend has continued into 2024 with over $1.1 billion worth of inflows so far. New issuance of municipal bonds continued to be well received from institutional investors.
These surging inflows form a tight back-stop for the sector and have the potential to ignite capital gains if supplies stay tight.
High Times in High Yield
Another pocket of strength in the municipal bond market could come from high yield munis. Thanks to their revenue-backed nature, high yield munis are offering junk bond-like yields without the same level of credit risk. Last year featured low default rates for these munis and this year is already shaping up to be similar.
According to Lord Abbett, investors have a rare opportunity to grab these yields and position themselves for further gains as the combination of coupon payments and discounts to par are realized.
The second theme within high yield is that not all high yield munis are equal. The vast bulk of defaults in recent times have come from a select group of hospital and senior living focused bonds. COVID and the pandemic hit these bonds hard, pushing up default rates. However, removing these from the equation results in a strong return picture. For investors, finding pockets of strong credit amid high yield could lead to outsized returns.
Adding Some Muni Strength
In the end, municipal bonds are offering some of the best yields in decades and there are plenty of opportunities in the sector going forward. Strong credit fundamentals, select high yield opportunities, and newfound investor demand are all some of the reasons why the sector looks attractive for the rest of the year. Given the potential, investors should consider adding them to a portfolio.
Municipal Bond ETFs
These funds were selected based on their exposure to municipal bonds at a low cost. They are sorted by their YTD total return, which ranges from -0.6% to 0.2%. They have expense ratios between 0.05% to 0.65% and assets under management between $1.2B to $36B. They are yielding between 1.9% and 3.6%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| FMB | First Trust Managed Municipal ETF | $1.9B | 0.2% | 3.2% | 0.65% | ETF | Yes |
| SUB | iShares Short-Term National Muni Bond ETF | $8.7B | 0.1% | 2% | 0.07% | ETF | No |
| MUNI | PIMCO Intermediate Municipal Bond Active ETF | $1.3B | -0.1% | 3.6% | 0.35% | ETF | Yes |
| MUB | iShares National Muni Bond ETF | $36B | -0.3% | 2.9% | 0.05% | ETF | No |
| VTEB | Vanguard Tax-Exempt Bond ETF | $34B | -0.5% | 3.1% | 0.05% | ETF | No |
| DFNM | Dimensional National Municipal Bond ETF | $1.2B | -0.5% | 2.6% | 0.19% | ETF | Yes |
| SHM | SPDR Nuveen Bloomberg Short Term Municipal Bond ETF | $3.9B | -0.6% | 1.9% | 0.20% | ETF | No |
Overall, Lord Abbett predicts that municipal bonds should continue to offer good returns for portfolios. Driving those returns will be these five themes. For those looking for income, munis are a great choice.
The Bottom Line
After spending much of 2022 and 2023 lower, municipal bonds may have plenty of strength to win this year. That’s because five distinct themes and trends are starting to emerge. For investors, these trends should help propel the sector.
1 Lord Abbett (February 2024). Municipal Bonds: Five Key Themes for Today’s Market
