Manulife Inves… - Thu, 01/18/2024 - 13:59

Have investors missed the opportunity in municipal bonds?

Municipal bonds closed out the year with a period of equity-like returns as yields have retreated since late October. Have investors missed the generational opportunity in the municipal bond market? Not in our view.

Over the last several months, we’ve seen a sharp rebound in municipal bonds. Decade-high starting yields paired with a cool-off in rates have caused the Bloomberg Municipal Bond Index to surge by 8.86% from when rates peaked on October 30 through the end of the year, providing investors the rare chance to receive equity-like returns from high-quality bonds.

Now that this scenario has materialized, the next logical question to ask is what now? Investors who've chosen to hide out in cash might be left asking if they’ve missed the opportunity in municipal bonds. As an asset class, municipal bond mutual funds have lost nearly $28 billion over the course of 2023.1 Although this pales in comparison to the $144 billion in outflows seen during 2022, it suggests that many investors are still waiting on the sidelines for fixed-income market volatility to subside. We can see evidence of this as there’s nearly $6 trillion still sitting in money market funds, and $2.1 trillion in CD balances in U.S. banks.2 The good news for these investors is that, in our view, there’s still a strong possibility for robust returns for this asset class in the year ahead.

Municipal bond yields remain elevated

One of the main drivers of strong municipal bonds over the last several months has been a sharp falloff in rates, with the yield to worst on the Bloomberg Municipal Bond Index falling to 3.22% from its recent peak of 4.50%.

Muni yields have fallen but remain elevated

Yield to worst (%)


Source: Bloomberg, Manulife Investment Management, as of December 31, 2023. Yield to worst is the lowest potential yield calculated by taking into account an issue’s optionality, such as prepayment or calls. The Bloomberg Municipal Bond Index tracks the performance of the U.S. investment-grade tax-exempt bond market. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Despite this recent move, yields remain roughly 41% higher than the average yield seen over the past decade. We can’t predict where rates will go from here, but with current tax-equivalent yields still north of 5%, investors are still able to get significant tax-free income on the bonds we’re buying in the market today.

Tax receipts paint a strong fundamental picture

Credit conditions tightened over the course of 2023, and this is a trend that we don’t expect to shift anytime soon; however, the underlying fundamentals of the municipal market remain strong. This should prove to be supportive for the market even as tight financing conditions persist for quite some time. During the last several years, we’ve seen record growth in tax revenue for most state and local governments: In total, tax receipts are 24% higher than they were at this time in 2019.

Tax revenues have increased substantially since 2019

State and local government quarterly tax receipts (US$ billions)


Source: U.S. Bureau of Economic Analysis, Federal Reserve Economic Data, as of January 4, 2024. 

Additionally, we expect to see high levels of dispersion between tax revenues among various state and local governments, especially if the economy slows or enters a recession. Those who rely more heavily on sales tax and property tax for revenues are likely to be more resilient than governments that rely on income tax. Historically, sales and property taxes have tended to demonstrate far less cyclicality. This dispersion creates an opportunity for active managers who place a heavy emphasis on credit research, allowing them to take advantage of this dispersion in tax revenue.

Spread compression could boost returns

Another factor that should prove to be supportive is that credit spreads remain somewhat detached from the reality of the underlying fundamentals in our market, especially as you move down the credit spectrum. 

For much of the past year, municipal bond spreads have been pricing in a possible recession and have now risen above their five-year average. The possibility of spread compression for BBB and below rated munis could help boost total returns in the year ahead.

Spreads for BBB-rated munis have crept above their 5-year average

Yield-to-worst spread (%)


Source: Bloomberg, Manulife Investment Management, as of December 31, 2023. The yield-to-worst (YTW) spread is calculated relative to AAA-rated municipal bonds. YTW is the lowest potential yield calculated by taking into account an issue's optionality, such as prepayments or calls.

There are also technical factors at play that could be a catalyst for spread compression over the next 12 months. Although many investors do seem to still be waiting it out in cash, that money is going to eventually be looking for a home when short-term rates normalize. We believe that we’ll see at least a portion of those flows go back toward municipal bonds. Additionally, supply is anticipated to be lighter than average this year, especially for high-yield munis. Both factors could help to prop up the municipal bond market over the coming year.

While we believe that higher-quality municipal bonds should form the bedrock of an allocation in today’s uncertain market environment, portfolio managers that can take an opportunistic approach to the asset class stand poised to benefit from the elevated total return potential of BBB and below rated municipal bonds. 

The bottom line for investors

As we look ahead to another year, we think there’s still a lot to be excited about despite strong absolute returns experienced by the municipal bond market at the end of 2023. As the U.S. Federal Reserve nears the end of its tightening cycle and we begin to see some stability in rates, this should begin to attract more investors off the sidelines and back into municipal bonds. However, the past few months have shown that it’s not too early for investors to consider an allocation, taking advantage of still-elevated yields and a solid fundamental backdrop for municipal bonds.

1 CreditSights, data as of December 29, 2023. 2 S&P Global Market Intelligence, April 1, 2023 (most recent data available).

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