Munis Are Heading Toward 2024 With Pride

Daily trading sessions in the 2023 bond market have been rife with wide swings in valuations, yet we can say with certainty that the march toward higher yields has given rise to historically attractive fixed income entry points. Throughout 2023, we have seen yields within the fixed income space having a competitive footing against risk assets and given our call that bond yields are not likely to test new highs during the current rates cycle, opportunities abound to employ more rewarding asset allocation strategies in support of defensive portfolio construction. As we think about the remaining weeks of 2023 and the start of a new year, we must do so within the context of continued Central Bank policy, but unlike the prior 20 months, the rate backdrop should be more conducive to accretive decision-making outcomes. We view the coming months through a less disruptive lens as the financial markets should now have a better and clearer outlook in respect to the Fed’s monetary policy trajectory, which has lifted the target range of the Fed funds rate to between 5.25% - 5.5%, a 22-year high. Whether Chair Powell and team view current policy as sufficiently restrictive seems to be of limited consequence given that the financial markets appear to have already advanced that pronouncement with the futures contracts decidedly calling an end to the tightening sequence. The FOMC meets next and for the last time this year on December 12/13 with policymakers expected to hold short-term rates steady for the third consecutive meeting. This gathering will be accompanied by a revised summary of economic projections (SEP) that we expect will reveal updated projections for the Fed funds rate as well as for the outlook on GDP and inflation from September’s SEP. Contracts pricing are reflecting a late Q1 2024 pivot with a notable likelihood of a rate cut, yet we continue to see the earliest easing toward the back end of next year.

Leading up to the Thanksgiving holiday, munis were reflecting a firm tone and are heading toward 2024 with pride. Tax-exempt yield movement is directionally correlated with U.S. Treasury activity, yet munis are meaningfully outperforming UST on a MTD and YTD basis. Typical for this time of year, munis are appropriately responding to supportive technicals that should escort the asset class to single-digit positive returns at year-end and to continued strength through the opening weeks, and perhaps months, of 2024. Fairly active tax-loss harvesting seems to be distorting actual fund flow dynamics, yet we can expect to see over the near-term the emergence of more positive flow conviction. Should our expectations be met, it would stand to reason that relative value ratios would likely continue to back down somewhat. Market stability is a powerful thing where the issuer community is concerned, and with rising comfort over Fed policy, we can envision a greater number of issuers coming in from the sidelines next year. We anticipate heavier volume in 2024 relative to 2023 issuance, yet we do not expect to replicate or come close to the outsized issuance from 2020 and 2021. Our forecast range for 2024 is $390B - $400B, about 12% higher than what we anticipate for 2023. While we expect higher new-money issuance, we also forecast somewhat greater refunding activity, to be largely driven by the level of interest rate declines. We are also mindful that next year is an election year, and events and circumstances could alter issuance dynamics, although we are not anticipating any new impactful fiscal policies ahead of next November. We think that taxable muni issuance as a percentage of total volume next year could return to double digits.  

As market participants navigate through the remaining weeks of 2023, we expect munis to maintain their outperformance over Treasury securities. We will be especially curious to see if muni fund flows could at the very least slow their pace of withdrawals, and at most could reverse course to stage perhaps intermittent inflows. As mentioned, tax loss harvesting with attendant swap activity gives rise to year-end portfolio repositioning with much of the secondary liquidations ascribed to this seasonal phenomenon as a meaningful proportion of the sale proceeds are reinvested back into munis. Once we clear this cycle, we expect to see more normalized trading activity. The muni market is poised to enter 2024 from a relative position of strength. Credit quality remains strong across the broad array of sectors despite some noted areas of concern, absolute yields and attractive and competitive cashflows provide a compelling argument to put sidelined cash to work, improved relative value opportunities, although still distanced from fair value and historical norms, support future investment performance, and market technicals should drive outperformance. Taxable equivalent yield calculations make the value proposition that much more apparent, particularly with Federal, state, and local tax exemption factored in. Month-to-date, key fixed income cohorts are earning positive returns, largely tied to ebbing inflationary pressure and more attendant yield stabilization as the Fed seemingly concludes its tightening cycle, and such factors have now moved YTD performance into the green column just in time for the holidays. Munis are generally being well-placed in the primary and well-bid in the secondary and we expect this dynamic to hold steady through year-end, particularly as new issue supply remains seasonally lower. We note that the attractive cash-flows have created a strong “carry” component to performance providing an offset to the lack of price appreciation that has backdropped most of this year as well as defensive attributes ahead of an economic slowdown or perhaps even recession. The “carry” attributes will likely extend into 2024, although we expect less in the way of price erosion and more opportunities to experience meaningful price advancement. Heading into 2024, muni credit will be generally secure and future prospects will be closely tied to the overall growth trajectory of the national economy. Let’s understand that bond yields are not likely to drop as quickly as they have advanced. We have checked many of the “bullish” boxes in favor of tax-exempt investment opportunities from credit standing, a likely peak in bond yields, and relative value to attractive cash flows, portfolio diversification and defensive attributes. This combination should keep the shining star above the asset class in 2024.