2024 Municipal Bond Market Outlook

Lawrence Gillum (00:00):

Municipal bond investors experienced the same rollercoaster ride of emotions in 2023 that many taxable investors experienced as well. What started out as one of the best Januarys in recent memory for the Bloomberg Municipal Bond Index quickly turned into one of the worst Februarys on record, and monthly returns were mixed throughout the year until the index finally found its footing to end the year with positive returns. So, in this edition of the LPL Street View, we outline what could be in store for muni investors in 2024. Following the worst calendar year return in 40 years in 2022, the muni index returned an above-average 6.4% in 2023. The majority of the year's positive performance arrived during the final two months of the year, as the index returned 8.8% in November and December. The positive returns were a direct result of the perceived Fed pivot from more rate hikes to the potential for rate cuts in 2024.

Lawrence Gillum (00:57):

But despite the above-average returns generated in 2023, we think the muni market still offers value for tax-exempt investors for several reasons. First, despite the recent rally, valuations remain generally attractive. Starting yields matter for most fixed income markets, but particularly for the muni market, low credit risk and very low default rates allow investors a certainty that you don't get from many other fixed income instruments. And because starting yields take into consideration the underlying price of a bond, as well as the required coupon payments, starting yields are the best predictor of future returns. So, despite the rally to end 2023 index starting yields are still very attractive relative to history. As illustrated in this chart, despite strong performance to end the year, the index yield-to-worst was down just 0.33% to 3.28%, or 5.54% on a tax-equivalent basis and remains above its longer-term average.

Lawrence Gillum (01:54):

The elevated nominal yields and income opportunity offered by the muni market remains above the levels seen much of the past decade. Next, and while we're probably past peak fundamentals, they remain solid. Along with valuations, muni fundamentals are also an important part of the appeal for munis and fundamentals for the asset class are healthy and many municipalities continue to sit on ample rainy day and reserve funds. And though tax revenue collections are likely past peak levels, they remain healthy and above pre-pandemic trends. Shown here, 12-month trailing state and local revenues as of September were unchanged from the prior year, just 2% shy of record levels. While slowing tax collections are expected to contribute to headline deficits in 2024, strong labor and real estate markets should continue to support the historically high state and local revenues, elevated cash balances and favorable budgetary flexibility. However, supply/demand dynamics hold the key for performance in 2024.

Lawrence Gillum (02:50):

The muni market tends to be relatively illiquid. Unlike say the equity markets that trade on an exchange, muni bonds still trade over the counter. Moreover, despite all the disparate issuers, there are over 56,000 of them, the market in general is still relatively small. The $1.6 trillion market pales in comparison to the $6.6 trillion U.S. investment grade corporate market, for example. As such, supply/demand imbalances can unduly influence market prices much more than most other markets. So, from a supply perspective, total tax-exempt muni supply reached $328 billion in 2023, which was 5% higher than the previous year's level, but still nearly 17% below pre-2018 levels. And for 2024, issuance is expected to stay around these more muted levels, although if interest rates do fall meaningfully in 2024, then that motivation to increase issuance increases as well. Now, from a demand perspective, following the record, $116 billion mutual fund outflow cycle in 2022, muni mutual funds recorded an additional $6 billion of outflows in 2023.

Lawrence Gillum (03:58):

However, lost in that headline number for fund outflows was that 2023 saw investment moving out of short-term funds and towards longer dated investments, which could likely continue in 2024. With the Fed expected to cut interest rates in 2024 if history at least rhymes, we could see investor inflows into the market before yields move lower this year, which is what we expect. So, what does all this mean for investors? Fundamentals for the muni asset class are generally healthy, and many municipalities continue to sit on ample rainy day and reserve funds. And though tax revenue collections are likely past peak levels, they remain healthy and above pre-pandemic trends. The wild card in the short term remains the supply and demand dynamics for the asset class though. While 2024 issuance could continue the trend of lower net issuance, demand could accelerate as investors seek to take advantage of these still attractive yields by moving out of cash and other shorter maturity investment strategies before the Fed starts to cut rates, which we think could happen this summer. With nominal yields above levels seen much of the past decade, still strong fundamentals, and perhaps an improving supply/demand dynamic, we think munis could be poised for another solid year in 2024.

Lawrence Gillum (05:07):

Thanks for listening. And here's to a prosperous 2024.