Quarterly Update: Q4 2023
Tax-Exempt Strategies: As Munis Tiptoe Into Year-End, Yields Are Becoming Hard to Ignore
Key Points
- Rising rates pressure performance but set up long-term investors.
- Valuations are improving as curve inversion diminishes.
- Credit spreads are buoyed by delayed expectations for economic softening.
Municipal bonds seemingly ran the gauntlet during the third quarter as the Fed remains steadfast in its mission to achieve its dual mandate while embracing a “higher for longer” bias, per the dot plot. Elevated volatility resulted in 10-year benchmark municipal bond yields rising about 90 bps, compared to 73 bps in comparable Treasuries, leading to underperformance. According to Bloomberg, investment grade (IG) and high yield (HYM) municipal bond returns flipped red through the year’s first nine months. However, the price pressure has markedly improved buying opportunities in municipal bonds. For example, the yield-to-worst (YTW) on IG and HYM bond Bloomberg indices increased by approximately 80 bps (to 4.4%, or 7.25% tax-adjusted) and 55 bps (to 6.25%, or 10.5% tax-adjusted), respectively, during the quarter, settling nominal yields at their cyclical highs and well-positioning investors with a longer-term horizon to lock in attractive tax-efficient income streams.
Chart 1: Municipal Index YTW Reach Cyclical Highs
Source: Bloomberg, as of September 30, 2023
Indexes are unmanaged and do not reflect a deduction for fees or expenses. Investors cannot invest directly in an index.
The municipal bond yield curve’s upward shift improved the relative value versus comparable Treasuries. The 10- and 30-year AAA municipal/Treasury ratios increased to 75% (from 67%) and 92% (from 90%) during the quarter, suggesting the tax benefit of owning municipal bonds is more valuable to an investor. The shape of the yield curve is notably less inverted, further signaling the current attractiveness of municipal bonds. From a technical perspective, the summer is typically a seasonally demand-driven period of the year as maturities and redemptions exceed issuance. Gross supply is down nearly 15% YoY, partly attributable to the fiscal strength of state and local governments (SLGs) and the cost of borrowing and carrying charges on new money and refunding issuance. While issuance is likely to pick up during 4Q2023, based on previous patterns, continued unpredictability and volatility in the market are likely to temper any meaningful supply. The outflows within municipal bond mutual funds have yet to reverse YTD, but retail and strategic asset managers continue to take advantage of the generational yields available. Once additional clarity is achieved in regards to the end of the rate cycle and Treasuries stabilize within a narrower range, municipal bond demand from institutional accounts should return.
The gradual compression of credit spreads is an interesting dynamic in both IG and HYM bonds. Estimates for economic growth to stall and potentially experience a recession did not occur as widely expected. Despite an aggressive Fed, the economy has exhibited resiliency, which has benefitted the fundamental quality of municipal bond issuers. SLGs enjoyed back-to-back double-digit fiscal performance during FYs 2021 and 2022. Many issuers closed the books in FY 2023 in a position of strength as reserves sit near record highs. YTD troubled borrower statistics in HYM are low, per Municipal Market Analytics, but with isolated stress seen within senior living and rural hospital sectors. Nevertheless, the overall quality of municipal bonds is favorable, but we will continue to monitor issuers’ plans for guarding against a slowdown in the economy.
Chart 2: AAA Benchmark Municipal Yields Increased Sharply During 3Q2023
Source: Bloomberg, as of September 30, 2023
Past performance or performance based upon assumptions is no guarantee of future results. Indexes are unmanaged and do not reflect a deduction for fees or expenses. Investors cannot invest directly in an index.
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Index Definitions
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the US It is not an exact list of the top 500 US companies by market cap because there are other criteria that the index includes.
Bloomberg Barclays US Aggregate Bond Index (LBUSTRUU): The Bloomberg Aggregate Bond Index or “the Agg” is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
GT10: US Government Treasury Yield
Bloomberg Municipal Bond Index: The Bloomberg US Municipal Bond Index measures the performance of investment grade, US dollar-denominated, long-term tax-exempt bonds.
Bloomberg Municipal High Yield Bond Index: The Bloomberg Municipal High Yield Bond Index measures the performance of non-investment grade, US dollar-denominated, and non-rated, tax-exempt bonds.
S&P Leveraged Loan Indexes (S&P LL indexes) are capitalization-weighted syndicated loan indexes based upon market weightings, spreads and interest payments. The S&P/LSTA Leveraged Loan 100 Index (LL100) dates back to 2002 and is a daily tradable index for the US market that seeks to mirror the market-weighted performance of the largest institutional leveraged loans, as determined by criteria. Its ticker on Bloomberg is SPBDLLB.
Bloomberg US Corporate Bond Index: The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Bloomberg US High Yield Index: The Bloomberg US Corporate High Yield Index measures the performance of non-investment grade, US dollar-denominated, fixed-rate, taxable corporate bonds.
Bloomberg: LF98TRUU Index: The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded. This is the total return index level.
Morningstar SPBDLLY Index: Yield to maturity time series of the Morningstar LSTA US Leveraged Loan 100 Index. The Morningstar LSTA US Leveraged Loan Index is a market-value weighted index designed to measure the performance of the US leveraged loan market.
Bloomberg Investment Grade Index: The Bloomberg US Investment Grade Corporate Bond Index measures the performance of investment grade, corporate, fixed-rate bonds with maturities of one year or more.
Bloomberg Municipal Bond Index: measures the performance of investment grade, US dollar denominated, long term tax exempt bonds. Bloomberg US Treasury Index: includes all publicly issued, U.S. Treasury securities that are rated investment grade, and have $250 million or more of outstanding face value.
Investment Grade (IG) Municipal Bond Index: The Bloomberg US Municipal Bond Index measures the performance of investment grade, US dollar-denominated, long-term tax-exempt bonds.
High Yield (HY) Municipal Bond Index: The Bloomberg Municipal High Yield Bond Index measures the performance of non-investment grade, US dollar-denominated, and non-rated, tax-exempt bonds.
Definitions
Yield to Worst (YTW) is the lower of the yield to maturity or the yield to call. It is essentially the lowest potential rate of return for a bond, excluding delinquency or default.
P/E Ratio: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS).
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*Source: City National Rochdale proprietary ranking system utilizing MSCI and FactSet data. **Rank is a percentile ranking approach whereby 100 is the highest possible score and 1 is the lowest. The City National Rochdale Core compares the weighted average holdings of the strategy to the companies in the S&P 500 on a sector basis. As of September 30, 2022. City National Rochdale proprietary ranking system utilizing MSCI and FactSet data.
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