Muni Investors Rewarded by Patience To Start 2024

January update

  • Municipal bonds posted negative total returns as the market reassessed macro expectations.
  • Seasonal supply-and-demand dynamics were supportive, albeit less so than in prior years.
  • We maintain some caution until absolute and relative valuations are more attractive.

Market overview

After posting the strongest performance since the mid1980s during the fourth quarter of 2023, municipal bonds took a breather in January. The asset class produced modestly negative total returns amid a macro-backdrop that generally unfolded as anticipated (see our 2024 Municipal Market Outlook). Economic growth remained firm and continued to eclipse projections, causing the market to reduce forward expectations for monetary policy easing, both in timing and in magnitude. As a result, the Treasury curve steepened with front-end rates falling and back-end rates rising. Given rich valuations, municipals modestly underperformed comparable Treasuries, and the S&P Municipal Bond Index returned -0.15%. Shorter-duration (i.e., less sensitive to interest rate changes) and single-A rated bonds performed best.

Supply-and-demand dynamics were supportive to start the year but provided a more muted seasonal tailwind than in prior years. Issuance increased to $32 billion in January, 16% above the five-year average. Despite the pickup, supply was still outpaced by reinvestment income from maturities, calls, and coupons by $2 billion. Consequently, issuance was easily absorbed with deals oversubscribed 4.7 times on average, above the 4.3 times average in 2023. At the same time, mutual fund flows turned consistently positive, benefiting from the end of seasonal tax loss harvesting. However, the moderate pace of inflows indicated continued caution from investors.

We believe that persistent economic strength, patience from the Federal Reserve, and weakening seasonal supply-anddemand dynamics could spur better valuations later in the quarter. Thus, we maintain near-term caution, but would view any material sell-off as a buying opportunity.

Strategy insights

We favor a neutral duration posture overall. We continue to advocate a barbell yield curve strategy, pairing front-end exposure with an increased allocation to the 15 - 20-year part of the curve. We prefer lower-rated investment grade credits, but think high yield offers an attractive risk-reward opportunity, given favorable structures and the ability to generate alpha through security selection.