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Written by: JB Golden | Advisor Asset Management
With record-setting heat across the nation there is no doubt summer is here, but heading into the summer months the municipal market is setting a markedly different tone than spring. As of June 11, 2024, the broad municipal market is up slightly more than 1% month-to-date, in stark contrast to the first half of the year. While losses have been modest — with the April loss of 1.24% the worst of the year — the market has also only posted one positive month this year. To end May, the market was down almost 2% year-to-date and in the short span of two weeks has taken back roughly half the year-to-date losses.
This speaks volumes on the importance of investing for time in the market rather than attempting to time the market; the bulk of long-term returns is, and always will be, coupon income not price changes. However, the June rally does seem to reflect building tailwinds for the asset class. Yield levels now sit at some of the highest all year and provide a meaningful pickup relative to cash and money market. Strong summer technical factors could be supportive of the asset class in the near term and interest rates sit near the top end of their recent range, hopefully leaving the Fed to play less of a role in the back half of 2024. Finally, the asset class provides an all-weather, “any landing” hedge against recent uncertainty. With municipals lagging investment-grade corporates and U.S. Treasuries on a year-to-date basis, a rally could be overdue and the summer season could be just the catalyst the market needs.
One of the hallmarks of 11 straight rate increases and the highest Fed Funds rates in over 20 years has been money market rates north of 5%. The U.S. 3-Month T-Bill (T-Bills -or- Treasury Bills have short-term maturities and pay interest at maturity), which tracks the Fed Funds rate, has increased from 0.03% in December of 2021 to 5.40% to end May of 2024. As a result, money market funds have offered yields above 5%. High, short-term rates coupled with an inverted yield curve left cash rates at some of the highest levels in over two decades, exceeding the available yields on short to intermediate municipals. This has been a headwind for municipal markets for some time as the value proposition in tax-exempt municipals gets distorted when cash rates exceed the taxable equivalent yields in the municipal market. The broad municipal market yield-to-worst has averaged 3.23% in 2024, which at a 35% federal tax rate would be a taxable equivalent yield of approximately 5% [3.23 ÷ (1-0.35) = 4.97], well below the 5.38% 2024 average for the U.S. 3-Month T-Bill. As of early June, the yield-to-worst of the broad municipal market sat just shy of 3.80%, 60 basis points higher than the year-to-date average and one of the highest levels since last November. On a taxable-equivalent basis that 3.80% equivocates to a 5.85% at a federal tax rate of 35%, almost 60 basis points better than the prevailing 3-Month rate of 5.25% as of June 11, 2024. Municipals enter the summer months well ahead of short-term Treasuries on a tax-equivalent basis. This could be supportive of the asset class moving forward, especially as the Fed enters their endgame, which could make the reinvestment risk inherent in money market a more important consideration.
The June performance for municipal markets is even more impressive when one considers the market digested the largest new issue calendar in more than two years to kick off the summer. State and local municipalities issued almost $16 billion in new debt to kick off the first week of June, a trend that is likely to continue as waning federal aid post-COVID no longer provides support. One of the factors supporting the market strength was the heavy reinvestment demand which should continue through the summer months. Most states fiscal calendars run from July 1 to June 30, and the recent spate of issuance could reflect a rush to market ahead of closing out the fiscal year. Above average supply is likely not going to continue. Demand normally outpaces supply during the summer months, but visible supply 30 days ahead indicates it could be especially acute this year. Supply and demand technical factors likely support strength in the near term and could provide an impetus for summer strength in the land of municipal bonds.
The macroeconomic backdrop also seems supportive of the asset class heading into the summer. We believe municipals could perform well under an “any landing” scenario whether soft or hard and anecdotally there seems to be a recent recognition of the value of the asset class in that regard. Recent data has created some uncertainty as to the path forward for the U.S. economy, with weaker-than-anticipated consumer spending juxtaposed against stronger-than-anticipated labor markets. A soft landing scenario is predicated on the Federal Reserve vanquishing inflation. In our opinion, the Fed is not going to ease into strong labor markets without further evidence that inflation is on the way down. A “soft landing” assumes the Fed can balance continued strength in the labor market while at the same time getting inflation under control. While this does not seem likely in our view, it could be a good environment for municipal bonds. Under a soft-landing scenario, both risk assets and higher-grade fixed income could benefit with falling inflation, lower interest rates and economic strength. The Federal Reserve has been messaging for several years now that slower economic growth might be the pill markets need to swallow to contain inflation. While slower growth is not synonymous with recession the “variable and lagged” impacts of monetary policy and the highest Fed Funds rate since the turn of the century seem to increase the odds. Higher grade municipal bonds, much like U.S. Treasuries, generally can be a safe haven/flight to quality asset class, notwithstanding a credit-led downturn such as 2008. With concerns building over the state of the U.S. balance sheet and 12 states with an equivalent or higher credit rating than that of the federal government, we think municipal bonds could perform well in a hard-landing scenario and would also likely be supported by easing monetary policy should it occur. Regardless of the outcome, we believe municipal bonds seem to provide a nice hedge against the current economic uncertainty and might provide investors with a way to beat the heat this summer.
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