Surprises in the consumer price index (CPI) diminished rally expectations and turned muni bond market performance negative.
Historically, muni performance has tended to be positive in the summer, typically starting in May and lasting through August.
Municipal credits are in good shape, with federal pandemic aid and healthy tax collections strengthening balance sheets.
So far in 2024, the municipal bond market, and much of fixed income, hasn’t performed as many had expected at the beginning of the year. The furious rally at the end of 2023 was likely too quick and sharp, based largely on expectations of multiple Fed rate cuts in 2024. First quarter upside surprises in Consumer Price Index (CPI) data diminished those expectations and turned bond market performance negative by April.
This pullback may have created an interesting entry point for muni investors. We’ve also just entered an historically strong seasonal period for munis, which typically starts in May and lasts through August. Muni market performance has tended to be positive over the summer months (see chart below.) The Bloomberg Municipal Bond Index produced positive total returns every year since 2015, except 2022 and 2023. Looking at returns by month, July returns were positive every year since 2013, even in years with outflows, such as 2015 and 2022. Total returns in June and August were mixed.
Municipal market performance has tended to be positive over the summer months. The Bloomberg Municipal Bond Index has produced positive total returns every year since 2015, except 2022 and 2023.
In 2024, principal redemptions and coupon payments are estimated to total around $230 billion from May through August, while issuance is forecast to reach only about $160 billion.1 This large supply-demand imbalance should be a positive tailwind for muni investors. We expect these strong technical conditions to allow muni credit spreads to squeeze tighter.
In addition, the market is currently pricing a higher probability of a September Federal Reserve (Fed) rate cut, which seems to have started a rally in Treasury rates. This should be welcome news for muni investors, as we enter the summer months.
Municipal credits continue to be in good fundamental shape overall. Funds from federal pandemic aid and healthy tax collections continue to strengthen balance sheets, while fiscal restraint should help keep most credits in a resilient position. In 2023, Moody’s Investors Service and S&P Global Ratings upgraded more than 1,400 credit ratings and downgraded fewer than 350 — a combined upgrade/downgrade ratio of 4 to 1. We continue to believe that collectively, municipal credit is the strongest it’s ever been.
While this remarkable pace of upgrades versus downgrades will likely not be sustainable, we still expect relatively stable credit quality in 2024 and no significant increase in defaults. This view played out in the first quarter of 2024 as S&P upgraded 93 credits and downgraded 38. Moody’s wasn’t quite as positive, upgrading 153 credits versus downgrading 79. Combined, that’s slightly better than a 2 to 1 upgrade/downgrade ratio. It isn’t quite as strong as 2023, but still a positive signal to the muni market and investors.
According to the rating agencies, the driving force behind the strong pace of upgrades is the strength of the US economy and solid finances of municipal issuers. Revenue sources for municipalities, such as sales, property, and personal income taxes, are doing well and most municipalities prudently managed the influx of federal stimulus dollars related to the pandemic. At Invesco, our experienced, dedicated muni team of 23 professionals has seen a similar trend in our internal rating upgrades. Our team puts an internal rating on every position we hold and provides forward-looking guidance to help our portfolio team determine the risk-reward benefit, or lack thereof, of each holding.
The yield to worst (YTW) on the Bloomberg Municipal Bond Index ended April 2024 at 3.78%. Prior to the current Fed hiking cycle, April 2011 was the last time it reached that level. Even at the height of the pandemic in March 2020, the YTW on the index peaked at 3.52%. It’s important to note that muni bond interest is typically exempt from federal income taxes, so the tax-equivalent yield for a muni bond yielding 3.78% for investors in the tax bracket disclosure to show how you came up with tax-equivalent figure.2 For those willing to take on additional risk, the 5.66% YTW as of April 30, 2024 on the Bloomberg Municipal High Yield Bond Index could be even more compelling. While yields did top current levels briefly during the pandemic, we’d have to go back to July 2017 to see similar ones.
The bottom line: We don’t know when the Fed is going to start cutting rates. We have opinions based on current data, but they are, like the Fed’s, data-dependent, and the data change constantly. Fortunately, while we wait for the data to drive the Fed to lower rates, which should help muni performance, we believe we’re getting paid handsome income for waiting, which we haven’t seen in years.
Source: Bloomberg L.P., as Apr. 30, 2024.
Sources: Bloomberg L.P., US Internal Revenue Service, and Invesco as of Apr. 30, 2024.
Important information
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Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
Municipal bonds are issued by state and local government agencies to finance public projects and services. They pay interest that is typically tax-free in their state of issuance. Because of their tax benefits, municipal bonds usually offer lower pre-tax yields than similar taxable bonds.
Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. It is not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding tax penalties that may be imposed on the taxpayer under US federal tax laws. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax advisor for information concerning their individual situation.
A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated and should not be interpreted as indicating low quality. For more information on rating methodologies, please visit the following NRSRO websites: www.standardandpoors.com and select ‘Understanding Ratings’ under Rating Resources on the homepage; www.moodys.com and select ‘Rating Methodologies’ under Research and Ratings on the homepage; www.fitchratings.com and select ‘Ratings Definitions Criteria’ under ‘Resources’ on the homepage. Then select ‘Rating Definitions’ under ‘Resources’ on the ‘Contents’ menu.
Based on 2024 federal tax rates. For illustrative purposes only. Taxable equivalent = (tax-deferred interest rate) x [1 / (1 —your tax bracket)]. These numbers are hypothetical and for illustrative purposes only and are not a representation of future yields. Actual yields may be lower or higher than the example. Income exempt from regular federal income tax may be subject to the US federal alternative minimum tax, as well as state and local taxes. It is important to note that the tax advantages of municipal bonds affect only the interest they pay. Gains or losses from the sale of these bonds are taxed as capital gains or losses.
*(37% Federal Tax Rate + 3.8% NIIT) effective as of January 1, 2024. Irs.gov, as of November 9, 2023. Top marginal tax rate for single taxpayers with more than $578,125 in taxable income or couples with $693,750 or more. NIIT is the Net Investment Income Tax of 3.8% on investment income for single taxpayers with more than $200,000 in taxable income or couples with $250,000 or more.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.
The Consumer Price Index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics.
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