IN THIS ARTICLE
1. Investing through a mutual fund captures the municipal market opportunity
2. The specter of rising taxes increases the value of tax exemption
3. Deep analysis is necessary to find credits that will outlast headline risk
4. Capitalize on high yield market participants’ overcorrections
5. Individual investors embrace taxable municipal bonds in retirement plans
We are at the mid-point of 2024 and the landscape is beginning to shift. Inflation has resumed its downward trend, and the Federal Reserve is holding its policy rate steady. As inflation cools and the risk of rate hikes tends to dissipate, investors are looking beyond these issues pondering what will drive relative value in the municipal bond market next. This change in sentiment highlights the various complexities and nuances of the municipal market that were overshadowed by macroeconomic headlines over the past two years. Issues such as tax policy and emerging cracks in the riskier segments of the market underscore not only the importance of tax-free income streams but also the critical role of credit research in assembling a diversified, resilient portfolio. As always, we hope that investors find our insights and our self-assessments of these insights useful as they navigate the evolving municipal bond market.
Top Five MacKay Municipal Managers’ Market Insights for 2024:
1. Investing through a mutual fund captures the municipal market opportunity
Rationale
Since the end of 2021, prudent fund managers have increased dividend rates, restructured portfolios and harvested losses to manage future capital gains distributions. Simultaneously, many investors shed duration by retreating to exceptionally attractive yields on money market instruments. In response to a probable pivot by the Federal Reserve in 2024, we anticipate short term rates will decline while longer-term bonds outperform. Therefore, investors may consider securing longer duration and income durability in the near term. However, higher yields only matter if they are in your portfolio. We believe investors’ have the opportunity to acquire high accrual rates, active portfolio positioning and the flexibility essential to capture the market’s recovery is through mutual funds. Other professionally managed solutions are available, such as passive, index bound ETFs or buy-and-hold, laddered separately managed accounts. However, in our opinion, the rigidity of their constrained investing approaches limits their efficacy. In 2024, we believe municipal market prices will rise and mutual funds will provide a compelling vehicle to capture that performance potential.
Portfolio in Action
We believe that active portfolio positioning and flexibility are providing an edge so far this year.
For example, the municipal yield curve has been inverted all year. In our portfolios, we actively positioned outside the intermediate segment of the curve, the most richly valued and lowest-yielding segment. This posture enabled us to continue capturing relatively attractive, more durable income streams at favorable values for our portfolios.
In contrast, rules-based passive strategies and bond ladders often face constraints that limit their potential performance. Specifically, strategies restricted by maturity may find themselves lagging better-diversified peers as the yield curve begins to normalize.
Mid-Year Status
On Target:
- Portfolios concentrated in the lowest-yielding, most richly valued portion of the municipal curve underperformed the broader investment grade (IG) market by 120 basis points (bps.) The Bloomberg Managed Money Intermediate (1-17 Yr) Index, an industry proxy for managed money accounts, returned -1.6%. The broad IG market benchmark, the Bloomberg Municipal Index, of which one third of its constituent holdings mature in more than 17 years, outperformed, returning -0.4%.1
- Curve positioning should continue to play a key role. Moving from a 1-year AAA-rated municipal bond to a 5-year AAA-rated municipal bond results in a loss of 27 basis points (bps) of yield per year. Meanwhile, a 25-year bond yields 3.6%, translating to a pickup of 71 bps of yield per year over the 5-year bond.2
2. The specter of rising taxes increases the value of tax exemption
Rationale
We believe anticipation of rising taxes will increase the value of tax exemption. In 2024, we expect Federal taxes due on elevated taxable money market earnings will renew investors’ tax awareness. Investors should recall that the Tax Cuts and Jobs Act of 2017 income tax provisions expire at the end of 2025.3 In addition, the Federal government will likely need other incremental revenues to finance its $33 trillion of debt.4 The bite of impending, higher Federal taxes may also be accompanied by state tax increases. For example, some states may face budget pressures as State and Local Fiscal Recovery Funds (SLFRF) grants are exhausted.5 We believe anticipation of higher taxes motivates investors to seek the attractive, legacy income streams of well managed mutual funds. While focusing on tax strategy now may seem early, we maintain it would be advantageous for investors to get ahead of potential tax increases.
Portfolio in Action
Concerns about future tax increases and the potential sunsetting of the Tax Cuts and Jobs Act have placed tax-exempt municipal bond mutual funds back to the forefront. We observe this through largely consistent positive net fund flows so far in 2024.
Mid-Year Status
On Target:
- Net flows YTD indicate $11.4 billion for all municipal bond mutual funds and ETFs. A nice reversal, so far, from the previous two years. We believe investors will increasingly focus on the value of tax-free income supporting steady demand in the future.6
3. Deep analysis is necessary to find credits that will outlast headline risk
Rationale
We continue to have confidence in the general condition of municipal credit despite some rising concerns to the contrary. The strength of municipal credit has become the subject of casual observers opining on the impact of a potentially slowing economic cycle. Despite the dire warnings, we believe that many municipal issuers have ample financial flexibility to weather this environment. For example, focus has been placed on the slowing growth of state and local tax bases due to stagnating personal incomes and wavering office property values. However, a deeper analysis reveals that revenue streams remain diverse and that last year’s collections reached all-time highs while budgetary reserves are nearly double that of pre-pandemic levels.7 In addition, municipal issuers have the capacity to raise revenues and cut expenses when needed to stabilize credit strength. Based on historical patterns, we expect municipal default rates should remain significantly more stable than corporate bonds even if the economy weakens more than expected.
Portfolio in Action
As anticipated, municipal credit fundamentals remained strong during the first half of 2024 and demonstrated resilience despite signs of a slowing economy.
Municipal credit rating upgrades outpaced downgrades by a ratio of 2.1 to 1.8
Moreover, the amount of Municipal defaults, which are historically rare, were down by 52% year-over-year through May 2024, according to BofA Global Research.
Mid-Year Status
On Target:
Using Illinois as an example, a state that receives elevated industry news coverage and a proxy for many other states from the sole perspective of rising credit fundamentals:
- Illinois was rated BBB- and on the verge of losing its investment-grade credit rating at the beginning of the decade.
- Today, the state holds a credit rating of A3/A-/A- (Moody's/Fitch/S&P) with a stable outlook. Illinois has managed to outlast negative headlines by passing balanced budgets on time, paying off debts, building reserves and funding its pensions.
- Recently, state lawmakers passed a balanced $53 billion budget on-time and the process transpired smoothly. Yield spreads on Illinois General Obligation debt subsequently dropped to their lowest levels of the year, reflecting reduced volatility and credit risk.
4. Capitalize on high yield market participants’ overcorrections
Rationale
In our opinion, there has been an historical pattern in the high yield municipal market where certain investors have used a selection process based on chasing yield somewhat indiscriminately. This can lead to overweight positions in weaker, less liquid and typically non-rated credits. The somewhat anomalous combination of rising bond yields and, for some issuers, improving credit conditions over the past two years has brought focus on the shortfalls of chasing yield. It has also confirmed the efficacy of using a risk-managed, relative value approach to investing in high yield municipal bonds. In our opinion, those yield-chasing investors will over compensate for historically chasing yield by indiscriminately selling and/or avoiding credits. Consequently, we believe more disciplined managers will be presented with opportunities to acquire better quality high yield municipal bonds at attractive levels. We expect discerning high yield municipal investors employing a credit research-driven, relative value approach to security selection will be rewarded in 2024.
Portfolio in Action
In 2024, high yield municipal mutual funds have seen solid inflows, a welcome change from the previous two years. This development has reduced the urgency for high yield investors to sell positions to meet redemptions.
Nonetheless, we observe instances where market participants are selling misunderstood credits at prices that don't reflect their true fundamentals. These selling decisions often stem from positions with modest book yields acquired when interest rates were much lower, making them less attractive in the current higher-rate environment.
Additionally, we believe some investors have been rebalancing their portfolios in favor of higher quality sectors and enhanced liquidity. Liquidity constraints during outflow cycles often lead to the sale of larger, more liquid names and sectors to meet redemption needs.
High yield sectors like Charter Schools and Land-Backed deals, which are typically smaller and often lack published ratings, face liquidity challenges during market downturns. Despite this, these sectors continue to present opportunities to acquire securities backed by strong financial metrics at attractive valuations.
Mid-Year Status
On Target:
- The Bloomberg High Yield Municipal Index returned 4.14% YTD, outperforming the Bloomberg Municipal Index, which returned -0.40%, by +454 bps.9
- We shifted our municipal asset allocation mix for the average moderate investor to 70% investment grade/30% high yield in February 2024. As of July 2024, we have moved the allocation to 75% IG/25% HY. This still represents an overweight to high yield municipals relative to our neutral posture of 80%/20%.
What’s Ahead for Municipal Markets in 2021
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5. Individual investors embrace taxable municipal bonds in retirement plans
Rationale
We expect U.S. based individual investor demand for taxable municipals will continue to increase. In our opinion, individuals will view taxable municipal bonds as an attractive complement to their investment grade corporate bond exposure in their qualified accounts. Taxable municipal bonds can offer attractive absolute yields, credit spreads and additional return potential with the same strong fundamentals as traditional tax-exempt financings. Additionally, 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. This one-two punch should increase demand and help propel returns in this often overlooked segment of the municipal marketplace in 2024.
Portfolio in Action
We believe taxable municipal bonds have met investor expectations this year. They are either outperforming or performing in line with key high-grade U.S. fixed income sectors and are doing so with a higher quality mix. Index spreads have tightened due to demand from diverse participants, including U.S. mutual funds.
The pace of new issue supply is picking up at the mid-year point. As a result, we expect to see more relative value opportunities that we can potentially capitalize on to drive total return across our portfolios.
Mid-Year Status
On Target:
- Mutual funds that invest primarily in taxable municipal bonds took in $98 million in positive YTD net flows.10
- Based on index returns, including taxable municipals within a diversified fixed-income portfolio has been beneficial so far this year. The ICE BofA Broad U.S. Taxable Municipal Securities Index generated excess returns over U.S. government bonds of +159 bps, outperforming the ICE BofA U.S. Corporate Index, which only generated +116 bps. This is notable despite the credit rating differential: 98% of the Taxable Municipal Index is rated A or above, compared to only 54% of the Investment-Grade Corporate Index.11
1. Source: Bloomberg as of June 30, 2024
2. Source: ICE Data as of June 30, 2024
3. https://www.taxpolicycenter.org/briefing-book/how-did-tax-cuts-and-jobs-act-change-personal-taxes
4. https://fiscaldata.treasury.gov/datasets/historical-debt-outstanding/historical-debt-outstanding
6. Source: LSEG Lipper Global Fund Flows, J.P. Morgan as of June 27, 2024
8. Source Moody’s, S&P, and Fitch as of March 31, 2024
9. Source: Bloomberg as of June 30, 2024
10. Source: Morningstar as of June 30, 2024
11. Source: ICE Data as of June 30, 2024
DISCLOSURES
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Past performance is not indicative of future results. It is not possible to invest directly into an index.
NOTE TO UK AND EUROPEAN AUDIENCE
This document is intended only for the use of professional investors as defined in the Alternative Investment Fund Manager’s Directive and/or the UK Financial Conduct Authority’s Conduct of Business Sourcebook. To the extent this document has been issued in the United Kingdom, it has been issued by MacKay Shields UK LLP, 80 Coleman Street, London, UK EC2R 5BJ, which is authorised and regulated by the UK Financial Conduct Authority. To the extent this document has been issued in the EEA, it has been issued by to NYL Investments Europe Limited, Hamilton House, 28 Fitzwilliam Place, Dublin 2 Ireland, which is authorised and regulated by the Central Bank of Ireland.
NOTE TO CANADIAN AUDIENCE
The information in these materials is not an offer to sell securities or a solicitation of an offer to buy securities in any jurisdiction of Canada. In Canada, any offer or sale of securities or the provision of any advisory or investment fund manager services will be made only in accordance with applicable Canadian securities laws. More specifically, any offer or sale of securities will be made in accordance with applicable exemptions to dealer and investment fund manager registration requirements, as well as under an exemption from the requirement to file a prospectus, and any advice given on securities will be made in reliance on applicable exemptions to adviser registration requirements.
MUNICIPAL MUTUAL FUND INVESTMENT RISK DISCLOSURE
Municipal bond risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated securities.
Diversification cannot assure a profit or protect against loss in a declining market.
Investing in municipal mutual funds involves risks, and there is no assurance that the investment objectives of any municipal mutual fund will be attained. Potential investors should consider the risks, fees and consult with a financial advisor before investing. The federal and state tax-free status of municipal bond income can be changed by legislative or regulatory action, potentially impacting the attractiveness and value of these securities. Investors should understand that the value of their investment can fluctuate and that they might lose money. Past performance is not indicative of future results. For detailed information about these risks, potential investors should read the fund's prospectus and consult with a financial advisor.
Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active management strategies typically have higher fees than passive management.
CREDIT RATING DISCLOSURES:
Bloomberg Credit Rating Disclosure (for index)
For rated securities, credit quality for index classification purposes is assigned as the middle rating of Moody's, S&P and Fitch; when a rating from only two agencies is available, the lower is used; when only one agency rates a bond, that rating is used.
ICE BofA Credit Ratings Disclosure (for index)
ICE BofA utilizes its own composite scale, similar to those of Moody’s, S&P and Fitch, when publishing a composite rating on an index constituent (eg. BBB3, BBB2, BBB1). Index constituent composite ratings are the simple averages of numerical equivalent values of the ratings from Moody’s, S&P and Fitch. If only two of the designated agencies rate a bond, the composite rating is based on an average of the two. Likewise, if only one of the designated agencies rates a bond, the composite rating is based on that one rating.
COMPARISONS TO AN INDEX:
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, portfolios within the composite are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
All ICE Data Indices referenced herein (Each such Index, The “INDEX”), are products of ICE Data Indices, LLC (“ICE DATA”), and are used with permission. ICE® is a registered trademark of ICE Data or its affiliates , and BofA® is a registered trademark of Bank of America Corporation licensed by Bank of America Corporation and its affiliates ("BofA") and may not be used without BofA's prior written approval. ICE DATA, its affiliates and their respective third part suppliers disclaim any and all warranties and representations, express and/or implied, including any warranties of merchantability or fitness for a particular purpose or use, including the Indices, Index data and any data included in, related to, or derived therefrom. Neither ICE Data, its affiliates nor their respective third party suppliers shall be subjected to any damages or liability with respect to the adequacy, accuracy, timeliness or completeness of the Indices or the Index data or any component thereof, and the Indices and Index data and all components thereof are provided on an “AS IS” basis and your use is at your own risk. Inclusion of a security within an Index is not a recommendation by ICE Data to buy, sell, or hold such security, nor is it considered to be investment advice. ICE Data, its affiliates and their respective third party suppliers do not sponsor, endorse, or recommend MacKay Shields LLC, or any of its products or services.
“Bloomberg®”, “Bloomberg Indices®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.
INDEX DESCRIPTIONS
ICE BofA US Corporate Index: The ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market
ICE BofA US Taxable Municipal Securities Index: ICE BofA US Taxable Municipal Securities Index tracks the performance of US dollar denominated investment grade taxable municipal securities publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch). In addition, qualifying securities must have at least one year remaining term to final maturity, at least 18 months to maturity at point of issuance, a fixed coupon schedule and a minimum amount outstanding of $250 million. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Original issue zero coupon bonds and ""global"" securities (debt issued simultaneously in the eurobond and US domestic markets) qualify for inclusion in the Index. Tax-exempt US municipal, 144a and securities in legal default are excluded from the Index. Index constituents are market capitalization weighted. Accrued interest is calculated assuming next-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the index.
Bloomberg Managed Money Intermediate (1-17 yr) Index: Bloomberg Managed Money Intermediate (1-17 yr) Index consists of fixed-coupon, tax exempt municipal bonds issued within the past five years with maturities greater than 1 year and remaining effective maturity no more than seventeen years, with a par value of at least $7 million and issued as part of a transaction of at least $75 million. Securities must be rated in the highest two rating categories by Moody’s, S&P and Fitch (based on middle rating if rated by three agencies, lower rating if rated by two agencies, sole rating if rated by only one agency). Bonds whose purpose is for health care or housing are excluded.
Bloomberg Municipal Bond Index: A rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following agencies: Moody's, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a date-date after December 31, 1990, and must be at least one year from their maturity date. Remarketed issues, taxable municipal bonds, bonds with floating rates, and derivatives, are excluded from the benchmark. The index has four main sectors: general obligation bonds, revenue bonds, insured bonds (including all insured bonds with a Aaa/AAA rating), and pre-refunded bonds. Most of the index has historical data to January 1980. In addition, sub-indices have been created based on maturity, state, sector, quality, and revenue source, with inception dates later than January 1980.
Bloomberg Municipal High Yield Index: An unmanaged index of municipal bonds with the following characteristics: fixed coupon rate, credit rating of Ba1 or lower or non-rated using the middle rating of Moody's, S&P, and Fitch, outstanding par value of at least $3 million, and issued as part of a transaction of at least $20 million. In addition, the bonds must have a dated-date after December 31, 1990 and must be at least one year from their maturity date.
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