In our 2024 annual municipal bond outlook, we wrote that municipal bonds would likely be an area of opportunity and that we expected positive total returns for the year. Our view at the time was that credit quality should remain resilient for most issuers, so investors should consider adding some lower-rated investment grade issuers—like those in the A/A and BBB/Baa categories—cautiously.1
Near the midpoint of the year, that outlook has been partially correct. The broad municipal bond market, as measured by the return for the Bloomberg Municipal Bond Index, is down about 0.6%, but lower-rated issuers have posted positive total returns to start the year and are outperforming higher-rated issuers. Going forward, we still believe that munis will post a positive total return for the year and that credit quality should continue to remain resilient.
Total returns should improve
Barring a big move up in Treasury yields, we think the worst for total returns is likely behind us. Most of this year's poor performance occurred during just two months—April and May—when the Bloomberg Municipal Bond Index was down 1.2% and 0.3%, respectively, for those months. Returns in June were strong due to falling rates and helped partially reverse some of the poor performance. Bond yields and prices move in opposite directions. Going forward, we estimate that the yield on the Bloomberg Municipal Bond Index could still rise by roughly another 0.2% and the index could post a flat total return for the year.
It's rare for the broad muni market to start the year on a rough note. It has only happened six times over the past 30 years and in three of those instances, the market went on to recover those early losses and posted a positive total return for the year.
The muni market typically has had positive annual returns, even with a weak start
Source: Bloomberg Municipal Bond Index, as of 6/28/2024.
Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Yields relative to Treasuries continue to be low, yet absolute yields are attractive
An issue that continues to plague the muni market is low relative yields, even though absolute yields are near the highest level in two decades. The yield for the Bloomberg Municipal Bond Index is about 3.8%, which is the equivalent of a 7.6% yield for a fully taxable bond for an investor in the top tax bracket and in a state with high income taxes.
Absolute yields are attractive
Source: Yield to worst of the Bloomberg Municipal Bond Index, as of 7/3/2024.
Assumes a 37% federal income tax bracket, a 10% state income tax and a 3.8% Net Investment Income Tax (NIIT). Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.
One metric we closely follow to gauge the attractiveness of highly rated munis is the muni-to-Treasury ratio, or the MOB (municipals over bonds) spread. It is the ratio of the yield on a AAA rated municipal bond to that of a Treasury before adjusting for taxes. Since the start of the year, muni-to-Treasury ratios for bonds with maturities of 10 years or less have hovered near the low to mid 60% level, which is the lowest level in over two decades. Said another way, an investor would need a federal tax rate of roughly 35% to 40% for the after-tax yield on a Treasury to equal that of a AAA muni. We believe the ratio has remained historically low this year due to supply and demand dynamics, which are two forces that aren't likely to change in the very near future. The size of the muni market continues to be constrained, yet demand for tax-exempt income has increased. Issuance this year has been strong but so has demand—especially for separately managed accounts, which tend to target higher-rated issuers in the intermediate part of the curve.
The MOB spread is below its longer-term averages for various maturities
Source: Bloomberg, as of 7/1/2024.
Past performance is no guarantee of future results.
We expect relative yield to remain low but there are some catalysts that could result in them going higher. If relative yields move higher, munis will likely underperform Treasuries.
What would it take for muni yields to rise relative to Treasuries?
1. Expectations for lower taxes. The 2017 Tax Cuts and Jobs Act, which lowered income tax brackets and rates, increased the standard deduction, and eliminated some popular itemized deductions, is set to expire at the end of 2025, barring action by Congress. Whether to extend some of the tax cuts will be one of the highest priorities for Congress in January, and the probability of them being extended will likely depend on the outcome of the election. We would be surprised if tax rates move lower, but if they did, it would likely result in less demand for munis and therefore an increase in yields relative to Treasuries.
2. Increased issuance. The amount of tax-exempt issuance so far this year has been strong even though yields are higher than in prior years. It's likely that many issuers are front-loading issuance prior to the November elections and that the pace of issuance will slow over the second half of the year. However, if rates move lower and borrowing costs get cheaper later this year, issuance could remain strong. Without an equal increase in demand, yields may have to move higher relative to Treasuries to entice new buyers.
Issuance of tax-exempt bonds has been high so far this year
Source: Bloomberg, as of 7/5/24.
Data for each year is through the 27th trading week of the year.
3. Concerns over credit. Credit quality has been a bright spot in muni land and although we believe we’re past the peak in credit quality, we still think the backdrop is generally favorable. However, if the economy substantially deteriorates, it could slow demand and push yields higher relative to Treasuries.
4. Credit quality has peaked but still looks positive. Overall, we don't have any major concerns about credit quality, although there are starting to be divergences in certain areas of muni land. State tax revenues have come down from their peak but are still up significantly since 2020. Also, the substantial amount of fiscal support that was provided to state and local governments has helped them bolster their rainy-day funds, which is akin to a savings account, to near record-level highs. States can tap into these funds, with restrictions, to help offset unexpected declines in revenues.
State tax revenues have risen
Source: U.S. Census Bureau, Quarterly Summary of State & Local Taxes, as of Q1 2024, which is the most recent data available.
Percentage change is based on the 4-quarter rolling average.
To illustrate the substantial impact that the surge in revenues has had on state finances, we looked at the trend in revenues from the end of 1999 through 2019, what we've termed as "pre-COVID" and compared that to the actual growth in state tax revenues. As shown in the chart below, total state tax revenues are nearly 10% higher than what they would have been if they followed the same growth rate from 1999 through 2019.
Total state tax revenues have exceeded their 1999-2019 growth rate
Source: U.S. Census Bureau, Quarterly Summary of State & Local Taxes, as of Q3 2022, which is the most recent data available.
"Pre-COVID trend" is the trend from 3/31/2000 to 3/31/2020.
Looking under the hood, not all state revenues are running above their pre-COVID trend. Five states—with California being the most notable because of its size and importance in the muni market—have revenues that are lower today than their pre-COVID trends. We don't anticipate this will lead to defaults but it's a headwind that will likely require prudent fiscal management.
Five states have revenues that are below their pre-COVID trends
Source: U.S. Census Bureau, Quarterly Summary of State & Local Taxes, as of Q3 2022, which is the most recent data available.
"Pre-COVID trend" is the trend from 3/31/2000 to 3/31/2020.
An additional bright spot for credit quality is that the starting point for credit quality is high. Over the past three years, ratings upgrades have accounted for about 70% of all ratings actions, according to Moody's Investors Service. This has been the strongest pace of upgrades relative to downgrades since the 2007-2008 financial crisis. As a result, the average credit quality of the Bloomberg Municipal Bond Index is now the highest it has been since 2007-2008.
Average credit quality is at the highest level in years
Components of the Bloomberg Municipal Bond Index. Monthly data as of 6/28/24.
What to consider now
Given low relative yields for AAA munis, we think investors who are not in a high tax bracket but are looking for highly rated investments in taxable accounts should consider certificates of deposit (CDs) or Treasuries, as they may yield more after considering the impact of taxes. However, for investors in higher tax brackets who are comfortable with taking on some added credit risk, we think adding some A rated issuers looks attractive. They offer an attractive balance of risk and reward, in our view, and can help offset low relative yields. Also, the backdrop for credit quality looks favorable, so we're comfortable suggesting taking on some added credit risk.
However, we're not as high on lower-rated munis issuers as we were to start the year, given the greater possibility of an economic slowdown now versus at the beginning of the year.
Why not venture all the way down to BBBs? Our concerns with the lowest-rated portion of the investment grade muni market largely stems from the size of the market. Nearly 95% of the issuers in the Bloomberg Municipal Bond Index are A rated or higher. Given the small size of BBB rated issuers, it can be difficult achieving adequate diversification, and liquidity can also be a concern. Additionally, BBB rated issuers have greater credit risks and don't offer the same diversification benefits as higher rated issuers do.
BBB rated issuers account for only 6% of all investment grade munis
Source: Components of the Bloomberg Municipal Bond Index, as of 6/28/2024.
Bottom line
Although the market is off to a rough start to the year, we think it should recover. We continue to have a favorable view of munis due to high attractive yields and generally favorable credit conditions. There may be bouts of volatility during the second half of the year largely due to the election. We would not be surprised if issuers slow their pace of issuance in November to avoid potential rate volatility. Additionally, tax policy is likely to be a hot topic on the campaign trail and muni yields may move in anticipation of tax law changes. We would caution investors from overreacting to what is said on the campaign trail because what is proposed versus what comes to fruition can, and often is, very different. For help selecting the right investments, reach out to your Schwab Financial Consultant.
1 The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.
