May 2024 Investment Commentary
With tax season now behind (most of) us, tax-sensitive investors assessing the federally tax-exempt municipal bond market face a richer environment from a valuation perspective. The post-pandemic period has witnessed far more municipal bond demand than net new issue supply, contracting some parts of the after-tax municipal yield curve below that of U.S. Treasury yields.
The Freedom Advisors investment team had an opportunity to meet with JPMorgan Asset Management for an in-depth discussion on the current fixed income landscape. The sector has seen across-the-board narrowing of credit risk premiums (the extra yield above U.S. Treasuries) required by investors to hold debt, including municipal bonds, considered riskier than Treasuries. Granted, a strong economy and fiscal support from the federal government make for a more conducive environment for taking additional credit risk. Investors should be mindful of whether their investments are being properly compensated with yield, including in the municipal market.
The Fiscal Outlook Looks Stable for Municipal Bond Issuers
- The fundamental backdrop can partially explain post-pandemic rich valuations of municipal bonds, between prudent budget management (i.e. aligning expenditures with revenue) and buildup of rainy-day reserves.
- Municipal bond issuers are also enjoying a positive ratings upgrade/downgrade ratio cycle, indicative of the ongoing economic expansion. Deterioration in this ratio typically begins at the onset of a recession.
- However, municipal revenue growth appears to be slowing down, as the initial burst of post-pandemic growth activity starts to fade as well as pandemic-level federal support.
Source: JPMorgan Asset Management, Used with Permission
Top-Rated Municipal Bonds Trade at Historically Rich Levels versus US Treasuries
- The 2.74% yield on the Bloomberg 10-Year AAA-Rated Municipal Bond Index is well below the 4.66% 10-Year U.S. Treasury yield as of 4/16/2024. This ratio (blue line) sits just below 60% versus a long-term average of 91%.
- On a tax-equivalent basis, using a 37% federal income tax bracket, the AAA-rated municipal yield is only 4.34%. That is below that of the comparable U.S. Treasury yield.
- It would seem the post-pandemic period has introduced a new regime of greater appetite for safe after-tax investments as investors are willing to earn less on municipal bonds than U.S. Treasuries on a tax-equivalent basis.
Intermediate Maturities (7-10 Year) Are Especially Rich Versus Short and Long Maturities on a Tax-Equivalent Yield Basis (Green Line)
- At the end of the 1st quarter, the tax-equivalent yields of intermediate AAA-rated municipal bonds were nearly equivalent to that of U.S. Treasuries. This spread has since turned negative through the month of April.
- On a tax-equivalent basis, more value can be found in both the short and long ends of the municipal bond curve.
- The intermediate part of the municipal bond curve has historically been favored by tax-sensitive investors who are less inclined to purchase maturities beyond 10 years. However, it is less clear as to what is driving the current rich premium levels versus history. JPMorgan notes that muni-focused SMAs have grown to $904 billion from around $700 billion in 2019 while bank, insurance, and individual households have reduced their municipal bond exposures, implying that SMAs appear to be less price-sensitive versus the latter investor categories.
Source: JPMorgan Asset Management, Used with Permission
Considerations and Current Investment Guidance
Fixed income remains attractive on an absolute inflation-adjusted basis, even municipal bonds on a tax-equivalent basis, especially if the U.S. economy experiences a soft landing of slow and steady growth. Advisors should be more deliberate in how they allocate client investments in the municipal bond market.
To best serve clients today and in all future economic and market environments, demand a model marketplace that gives you the choice and objectivity you need in the fixed income asset class. Freedom Advisors offers a wide selection of managed model portfolios in all these categories.
- Fixed income SMA
- Laddered bond portfolios
- ETF and mutual fund portfolios
- Dynamic/tactical portfolios
The Freedom Advisors investment team is focused on curating our model marketplace so you can focus on your clients and your business. If you would like to discuss the municipal bond market or learn about our complete portfolio management solution, schedule an introductory call.
Advisory services are offered through Freedom Investment Management Inc. (“Freedom”), a registered investment adviser. Investment strategies carry varying degrees of risk, including the total loss of principal. Freedom does not provide tax or legal advice.
While Freedom believes the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information. This material reflects the opinions of Freedom and is an assessment of the market environment at a specific time. This is not intended to be a forecast of future events or a guarantee of future results.
This should not be considered a recommendation to buy or sell individual securities, nor should this information be relied upon as research or investment advice regarding any security in particular. Diversification does not ensure a profit or protect against loss.
Except as otherwise specifically stated, all information is as of April 24, 2024.
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