Higher bond yields and expectations that the Federal Reserve will maintain or cut its benchmark interest rate this year have created a window of opportunity for institutional investors in the municipal bond market.
Muni yields reached 4.72 percent in October — the highest they had been in more than a decade — and have since fallen to 3.91 percent. Still, munis, for now, have relatively attractive yields.
“There needs to be a little sense of urgency with regards to this. Since the end of the third quarter and the beginning of the fourth quarter last year, we have been talking to clients about that sense of urgency. It’s not a market timing call necessarily, and people can confuse that,” Robert DiMella, executive managing director at MacKay Shields, said.
DiMella said investors should take advantage of higher yields on short-term munis while also start improving the durability of their income stream and that means increasing the duration and interest-rate risk of their portfolios. But he’s not suggesting that because he thinks the economy and interest rates are going to come crashing down. “It could, but the income on the short end is going to be fleeting.”
“In our view, demand from both domestic and overseas institutional investors should be robust in 2024 as credit spreads remain attractive and hedging costs will most likely recede with the normalization of yield curves around the world,” DiMella said.
Municipal bonds — the debt issued by local, county and state governments to build schools, bridges and other infrastructure — were on a roller coaster in 2023. Interest rates rose for much of the year and volatility was elevated before a dramatic recovery (bond prices rise as yields fall) in November and December. There were a record 12.8 million trades reported to the Municipal Securities Rulemaking Board in 2023, 3 percent more than in 2022.
Individual investors, seeking lower-risk investments and tax advantages, account for the majority of the nearly $4 trillion municipal bond market, but institutions also own muni bonds and funds. There are roughly 50,000 unique issuers in the market, which is why it remains fragmented and trades are still predominantly done over the counter.
“Thanks to a favorable mix of historically high yields, expectations that the Federal Reserve will ease off higher-for-longer interest rates, and attractive credit spreads, munis have seldom held as strong a potential as they do today,” portfolio managers at AllianceBernstein wrote in a note last week.
Other asset managers agree.
“I don’t think that we will get back to those [October] levels. I think that we may have some volatility and I actually think that indeed the Fed is getting closer to when they want to cut,” Scott Diamond, co-head of Municipal Fixed Income at Goldman Sachs Asset Management, told Institutional Investor. “If there’s volatility and yields move higher, you probably want to try and lean into that and get invested.”
The muni rally late last year isn’t deterring other fixed-income leaders either.
“Looking back at the last two years, and looking at this entry point relative to recent history, it still looks to be a good entry point if the Fed is at the peak” and is likely to reduce rates this year, said John Miller, chief investment officer of the high yield municipal credit team at First Eagle.
Robert Amodeo, head of municipals at Western Asset Management, said his firm has also been instructing clients to put cash on the sidelines to work while they can get good yields on short-term bonds and lock in higher yields on longer-term ones. He doesn’t expect any fundamental or technical forces to destabilize the muni market in 2024 so now is as good a time as ever, especially for individual investors. “Broadly, our view is that if you pay taxes, it’s always a good time to be buying municipal securities. So if you buy them now in the short-term, you probably benefit from where rates are today,” Amodeo said.
Every January, a lot of munis reach maturity but there are fewer new bonds issued than later in the year, creating a potential supply crunch. This moment might not be the absolute best to buy some of the bonds, but there should be higher yields to be had for at least part of this year.
“This is not an unusual conversation in mid-January to say, ‘munis look rich.’ We do this most Januarys, so you want to bide your time a little bit,” Matthew Buscone, co-head of portfolio management at Breckinridge Capital Advisors, a firm managing $37 billion of munis in separate accounts. “The absolute yields look okay, but from a relative value standpoint — we would consider ourselves more of a relative value focused buyer — there’s probably slightly better entry points from munis.”
