The municipal bond market underperformed in 2023 with 6.40% returns in investment grade, 9.21% in high yield tax exempt, and 8.84% returns in taxable.¹ This compared unfavorably to US Corporate returning 8.52%, corporate high yield returning 13.44%, and US Treasuries returning 4.05%, respectively, during the same period.^2,3,4

Attractive value proposition

As we look ahead into 2024, given the strong credit fundamentals and relative spreads on a credit-quality basis to their corporate counterparts, municipal bonds (munis) pose an attractive value proposition at this point in the cycle. Looking at five-year averages of the Bloomberg Municipal Index, both in the investment grade and high yield space, we see yields as compelling compared to their corporate counterparts. Investment grade is currently at about fair value, but on a risk-weighted basis heading into an economic slowdown, we believe investment-grade municipals offer better value than their corporate counterparts given the difference in historical default rates (Chart 1).

Source: Bloomberg U.S. Aggregate Corporate Index, Bloomberg U.S. Municipal Index, both as of December 2023.

The same can be said for high yield (Chart 2), with the high yield index offering a yield of 8.7% on a taxable-equivalent basis, which compares to a 7.7% in the corporate high yield, the 98 basis point (bp) spread is historically wide over the five-year average of 78 bps. It is also worth mentioning the difference in historical default rates as a reason why the municipal high yield market looks particularly attractive relative to corporates with a current five-year annual default rate of 0.08% versus 6.94% in corporates.⁵

Source: Bloomberg Municipal Bond High Yield Index, Bloomberg U.S. Corporate High Yield Index, both as of December 2023.

Technicals strong overall, but bumpy ride

We believe technicals will generally be favorable in 2024, especially in the first few weeks of the year as investors look to reinvest principal and coupon payments with little supply expected to start. However, we expect the market to wax and wane through the first half of the year as issuance picks up. From a supply perspective, we believe there will be an uptick in issuance in 2024 as rate stability and funding gaps encourage issuers to come to market.

Demand in the municipal bond space has been driven primarily by separately managed accounts (SMAs) and exchange-traded funds (ETFs) for 2023. This, we believe, will continue at least for the first half of 2024 until investors have better visibility on the Fed path possibly leading into the second half of the year. However, the increasing frequency of discussions concerning tax hikes across municipalities in the US may help to bolster the demand for tax-exempt municipals in the interim.

We would note, however, that continued strength of the consumer and labor market could push back expected cuts, the first of which is expected to take place in March 2024, which may delay the expected strength in technicals to later in the year.

Sectors to watch in 2024

The fundamentals of the municipal bond market remain solid and has benefitted from the resilience of the consumer and labor market, which has resulted in strong tax collections, although they have declined from their recent peaks. We believe several sectors may offer attractive entry points.

Transportation

We have seen increased travel both in toll roads and airports, which have shown considerable bounce back from pandemic-era lows. That, along with federal funding, has provided a relatively stable credit environment in these sectors.

Hospitals

We believe there are opportunities in this particular area of the healthcare sector as spreads have lagged the rest of the high yield and investment-grade space. We have seen admissions rebound as well as cost concerns and wage pressures start to abate. Furthermore, those with scale stand to benefit in a sector that is ripe for consolidation.

Education

As we have shed light on throughout the majority of 2023, charter schools continue to demonstrate an agility in the ways it has been able to adapt its operating model to different learning environments and has been less exposed to as large of a labor cost increases as its unionized counter parts. The sector has also benefitted from increased per-pupil funding as well as a rise in demand. Valuations still look attractive with spreads at levels that are wider than the underlying credit quality would indicate.

Local general obligation

Local general obligation issuers are less reliant on income and sales tax, which tend to be more volatile in an economic downturn and more reliant on property taxes. These tend to be more stable than their state general obligation counterparts.

We will continue to remain cautious about other sectors, such as sales tax bonds and mass transit, to start of the year. Sales tax bonds, which characteristically underperform in a deteriorating economic environment. At this time, they are trading at spreads that we believe are very high. The mass transit sector continues to face funding gaps due to, we believe, a lack of riders and an overreliance on local and state appropriations.

Final thoughts

We continue to view credit fundamentals as generally solid, albeit declining from their peaks. While some spread widening is to be expected in the high yield market in 2024, we expect credit to hold up and positive total returns to continue in the space.

Duration, while having been the enemy of total return for much of the past two years, is starting to look more attractive. However, given uncertainty around Fed policy and timing, we think it prudent to focus more on fundamentals and relative value opportunities, while implementing a barbell duration strategy across most of our funds.

With this economic uncertainty, and a continued inversion in the belly of the municipal bond curve, we are not yet comfortable with significant overweight in duration and feel that the window of opportunity to extend and invest in the belly may remain should Fed policy stay higher for longer.

¹ Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD.
² Bloomberg U.S. Aggregate Index, December 2023.
³ Bloomberg U.S. Corporate High Yield Bond Index, December 2023.
⁴ Bloomberg U.S. Treasury Index, December 2023.
⁵ Moody's Investor Services, December 2023.

Important information

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-271223-172340-1