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).
Important Disclosures
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional
Australia: Manulife Investment Management Timberland and Agriculture (Australasia) Pty Ltd, Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. Mainland China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad 200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Manulife Investment Management Timberland and Agriculture Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.
3323783
