Global transitions and municipal allocations

Bottom line up top

A slew of economic data and some unexpected election outcomes jostled for investor attention last week and could have significant implications for global financial markets in the near-to-medium term.

Modi, Morena and a majority-less ANC. The week began with election results in three key emerging markets: India, where Prime Minister Narendra Modi’s party underperformed at the polls, forcing him to rely on broader coalition support to stay in power; Mexico, where the Morena Party’s Claudia Sheinbaum became the first woman to be elected president, but faces a host of daunting issues; and South Africa, as the long-dominant ANC Party once led by Nelson Mandela was rebuked by voters amid government corruption concerns and was left scrambling to find coalition partners. These three outcomes serve as an important reminder to investors that political risk events can become a source of instability at any time.

Mixed U.S. labor market data and a European policy pivot complicate the interest rate outlook. Trends in inflation and employment data have played a role in the timing of both actual and perhaps even potential rate cuts. In the U.S., the Bureau of Labor Statistics’ JOLTS (Job Openings and Labor Turnover Survey) report for April showed that job openings fell to 8.1 million, their lowest level in more than three years, while the Atlanta Fed Wage Tracker also showed an April downtick (Figure 1). The implications of this softer data were countered by Friday’s surprisingly robust monthly payrolls report for May, which came in at 272,000, well above the consensus estimate of 185,000. Moreover, year-over-year wage inflation as measured by average hourly earnings growth (+4.1%) was up from the previous month’s 3.8%. Bond yields moved higher in response to Friday’s data and the odds that the Federal Reserve will cut rates twice in 2024 diminished. Meanwhile, in the eurozone, moderating inflation prints over the past year led the European Central Bank to cut rates for the first time since September 2019.

While the long-term ramifications of last week’s events and data remain to be seen, the current investment landscape still offers opportunities for investors to take advantage of compelling yields, healthy fundamentals and strong technical backdrops for certain fixed income classes, including municipal bonds.

Portfolio considerations

U.S. bond yields remain near their highest levels of the past 17 years. Although economic growth and sticky inflation have disappointed markets by pushing out a potential Fed pivot to rate cuts — most likely until the fourth quarter of this year, in our view — today’s elevated yields offer an attractive entry point for municipal bonds. U.S. investors in the highest tax brackets can realize taxable-equivalent yields ranging from 5.65% to 6.70% in municipal bonds (depending on the maturity), with even higher levels in states with income taxes (Figure 2). These yields continue to exceed those available on investment grade corporate bonds, mortgage-backed securities and the broad Bloomberg U.S. Aggregate Bond Index, yet they come with lower historical default rates.

In the below-investment grade space, high yield municipals are yielding 5.6%, resulting in a 9.5% taxable-equivalent yield. That’s 4.4% percentage points more than the yield on the Bloomberg Aggregate and 1.5% greater than high yield corporates. About 75% of the high yield municipal bond index is made up of higher-quality BB rated issues. Default rates for these BB rated munis roughly equal those of BBB rated corporates. The historical average default rate for high yield munis is between 1.2% and 1.5% over the past 19 years.

Muni credit fundamentals remain healthy following three consecutive years of robust revenue and 2024 tax collections that are roughly 25% higher than prior peaks in 2019 and 2020. Rating agencies have been increasing muni credit rating as well, with upgrades outpacing downgrades by an approximately 4:1 ratio for three years in a row.

So far this year, municipal fund inflows have totaled $10.5 billion, with more than half going into high yield munis. We expect this trend to continue, as high yield munis are a longer-duration asset class, and the municipal curve is much steeper than its Treasury counterpart. Investors are being rewarded for extending duration in municipals, locking in yields and positioning for eventual rate cuts. Meanwhile, muni supply has surged recently, pushing municipal/Treasury ratios higher and creating even more attractive entry points for investors ahead of the summer doldrums.

In the investment grade muni space, we favor the water/sewage sector. These bonds pay for an essential service for which demand is inelastic. Additionally, the sector benefits from ample liquidity and cash on hand from federal Covid relief programs. As for high yield munis, we continue to favor land-secured debt used to finance essential infrastructure for new residential housing developments. Strong housing demand and depressed selling due to high mortgage rates have pushed buyers into new housing communities, which supports sector credit quality.