CONTRIBUTORS
Ben Barber, CFA
Director, Municipal Bonds,
Franklin Templeton Fixed Income
Jennifer Johnston
Director of Research, Municipal Bonds,
Franklin Templeton Fixed Income
A year of significant monetary policy tightening is coming to a close.
In the face of a persistently strong US economy, the US Federal Reserve (Fed) had to continue tightening monetary policy throughout most of 2023. A resilient labor market and decelerating inflation supported consumer spending and economic output. In fact, since the economy remains on solid footing while price pressures—though easing—appear to be “sticky,” we believe the Fed will likely prefer to err on the side of caution and keep monetary policy restrictive for longer to ensure a sustained return of inflation to its 2% target.
Going forward, we expect a more constructive backdrop for fixed income investors.
The past year saw heightened levels of volatility across fixed income markets as investors tried to assess the likelihood that the Fed would achieve a “soft landing.” This, in turn, weighed on municipal (muni) bonds, with the sector witnessing significant retail fund outflows. However, it is very likely that the Fed has reached the end of its hiking cycle. We believe that interest rates will now need to remain at or close to current levels for much of 2024 in order to secure a sustained decline in inflation. The good news is that greater certainty around the central bank’s monetary policy should mean less volatility, while declining yields should provide a tailwind for bond investors over the coming year.
A closer look at the muni-bond market.
We remain optimistic about muni bonds going into 2024 and believe that there are opportunities to find value across the credit spectrum.
- Technicals have the potential to be constructive for the sector going forward.
Uncertainty around the Fed’s policy rate path and the US economy’s resilience kept investor demand anemic in 2023. However, we understand through anecdotal feedback that asset allocators retain high cash and cash-equivalent balances, waiting on the sidelines for volatility to decline or compelling opportunities to arise. Since muni bonds now offer historically elevated yields, which can be particularly attractive for those investors who target tax-adjusted yields, we expect investor flows to return to this sector going forward. Moreover, the longer-duration nature of the asset class can potentially reduce the reinvestment risk, present with the recently popular money market instruments. A major catalyst that we are looking at for inflows to pick up more significantly is the flattening of the US Treasury yield curve inversion and a return to its more typical upward-sloping shape. A sustained increase in demand should support muni-bond performance over the coming months.
- Issuer fundamentals remain stable.
We believe fundamentals in the muni market remain stable and should be supportive of the asset class over the medium to long term. While slowing economic activity and rising costs have led some municipalities to forecast deficits in the upcoming budget cycle, this does not currently raise our concerns. State and local governments have many tools to address any potential challenges that may come their way, particularly as they still retain large “rainy-day” funds that were bolstered by federal COVID-19 aid, increased during the pandemic recovery, and maintained with conservative budgeting and fiscal discipline. Nevertheless, a disciplined fiscal approach will remain crucial to deal with rising wages, labor shortages, higher borrowing costs and the slowdown in economic growth.
- Compelling value can be found across the credit spectrum.
Muni-bond yields continue to hover near multi-year highs and look particularly compelling to us on an after-tax basis (i.e., for those investors who can take advantage of tax-adjusted yields). Since inflation appears to be relatively contained and the Fed has likely reached its terminal policy rate, borrowing costs may start to decline as we move through this coming year. As a result, investors may seek to reallocate funds to the sector in order to lock in these historically attractive yields. Additionally, when compared to corporate debt, tax-free muni bonds tend to display lower default characteristics, meaning that the asset class can offer a strong investment option for clients seeking risk-adjusted returns across the quality spectrum.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.
Active management does not ensure gains or protect against market declines.