Is now a good entry point for muni bond investors?

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 credit fundamentals remain strong

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.

We’re getting paid to wait

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.