Municipal Bonds Shine Amidst Rate Cuts and Election Uncertainty: Experts Weigh In
With the Federal Reserve’s rate-cutting cycle expected to begin and the November election just around the corner, now could be an opportune moment to invest in municipal bonds. As interest rates fall, municipal bonds offer a way to lock in yield, thanks to their tax-exempt nature and the fact that many are long-maturity and longer duration. "Municipals are a great way to do that, given the tax-exempt nature, and given that a lot of municipals are longer maturity and longer duration," said Matthew Norton, chief investment officer for municipal bonds at AllianceBernstein. Duration measures a bond’s price sensitivity to rate fluctuations; bonds with longer maturities generally have greater duration. "Once we see that first Fed cut, and we see money coming out of cash, we do see an environment where municipals could meaningfully outperform," Norton added.
Key Takeaways:
- Interest rates are expected to fall, making municipal bonds attractive for locking in yield.
- Tax-exempt status makes municipal bonds particularly appealing in a potentially higher-tax environment.
- Increased supply in the primary market is expected to slow by Election Day, presenting a buying opportunity.
- Election uncertainty could lead to tax changes, impacting muni bond returns.
- Fundamentals and yields are at multi-decade highs, making municipal bonds a compelling investment.
Municipal Bond Advantages: A Closer Look
Interest earned on municipal bonds is free from federal tax. They may also be exempt from state taxes if the investor resides in the issuing state. These tax benefits are particularly valuable in a potential scenario of higher taxes, which is a possibility depending on the outcome of the upcoming election.
The primary market for municipal bonds, where new issues are sold, is expected to see a decline in supply leading up to the election. This is because issuers are often hesitant to release new bonds during periods of high political uncertainty. This expected slowdown in supply creates a potentially favorable environment for investors, as it reduces competition for existing bonds, potentially lowering prices and increasing their attractiveness.
"Buying now, when there’s a lot of paper and it’s cheaper, we think presents an opportunity," said Dan Close, head of municipals at Nuveen. "Once we have the new issue calendar grind, if not to a halt, at least to meaningfully less paper during and immediately after the election, that presents an opportunity because you’re not competing with the primary market."
Navigating Election Uncertainty: Tax Considerations and Portfolio Positioning
The upcoming election brings a lot of uncertainty about what will happen with the expected expiration of tax cuts at the end of 2025. Close explains that the potential for "meaningfully higher taxes" is already influencing financial advisors, prompting them to adjust their muni portfolios accordingly. "It’s just going to be really, really tough to go in to pass comprehensive tax reform," he added.
While acknowledging the potential for tax changes, Paul Malloy, head of U.S. municipals at Vanguard, advises focusing on the "noise" surrounding the election. "The macroeconomic backdrop and where we are, the economic cycle will have more influence on municipal bond returns than changes in the tax rates, but investors still absolutely need to be thinking about what might happen," Malloy said.
Impact of Potential Tax Changes: A Deeper Dive
Absent congressional action, certain provisions in the Tax Cuts and Jobs Act (TCJA) will sunset at the end of 2025. This means the lowered federal income tax brackets will revert to higher levels, with the top rate moving back to 39.6% from 37%.
"That’s actually very good news for municipals, because the municipal exemption just becomes worth that much more," said Close. For example, a muni bond yielding 5% has a taxable equivalent yield around 7.9% currently. With the new tax rate, that taxable equivalent yield would jump to 8.25%, he added.
The Alternative Minimum Tax: A Potential Impact
Another potential tax change involves the Alternative Minimum Tax (AMT). The TCJA significantly reduced the number of individuals subject to the AMT to around 200,000. However, if the legislation sunsets, this number could balloon to 7.6 million.
According to Close, "If we all of a sudden have 7.6 million taxpayers ensnared with AMT, we would anticipate that the spread you would need to be paid by buying the AMT paper would have to be wider."
As a result, Close is focusing on private activity bonds, specifically those tied to airports and housing, which issue with AMT preference in the muni market. "We’re … just saying, ‘Are we getting paid enough for the risk that the TCJA is not rolled?’"
The State and Local Tax Deduction: A Positive Outlook
The $10,000 limit on the federal deduction for state and local taxes (SALT) is also set to expire. While this impacts high-tax states like California, New York and New Jersey, it could have a positive impact on muni bond returns in the long run.
"We don’t think it’s going to necessarily stop residents from moving from New Jersey or New York or California to sunbelt states, but we do think that it does certainly slow it down a bit," Close said. "It would have a positive impact on the demographics and have a positive impact on just some of the longer-term credit metrics of many issuers, if it’s allowed to sunset."
Experts’ Strategies for Muni Bond Portfolios
Recognizing the current strength of municipal bond fundamentals and yields, experts are advocating for strategic portfolio positioning to maximize returns.
Vanguard’s Perspective: A Focus on Investment-Grade Munis
"Municipals are very much part of the ‘bonds are back’ story," said Malloy, highlighting the strong credit fundamentals of the muni market. He specifically favors investment-grade munis, particularly those rated A and BBB with durations of 10 years or less. These bonds are considered attractive, while those rated AAA and AA are deemed a bit pricey.
Nuveen’s Approach: A Barbell Strategy for Duration Risk
Close favors A, BBB, and below investment-grade munis, citing strong fundamentals and record cash reserves held by state and local governments. He emphasizes the technical strength of the market, noting that "these bonds still have room for credit spread compression." Close incorporates a barbell strategy when it comes to duration, favoring a combination of zero to two-year bonds and 15-year bonds. "You are getting paid to take duration risk," he said.
AllianceBernstein’s Strategies: Leveraging Rate Cuts and Credit Strength
Norton’s team at AllianceBernstein is embracing the opportunity presented by expected rate cuts. They are taking on more interest rate risk than usual, given the relative attractiveness of munis and the anticipation of falling interest rates. This strategy anticipates substantial inflows into the muni market as investors move away from cash.
"We think high yield funds in particular will receive a disproportionate amount of flows as the Fed starts cutting, which will narrow the spreads on lower-rated bonds and increase the prices of those lower-rated bonds," Norton said. He also leans towards a barbell strategy, combining one-year and 15- to 20-year bonds, citing its yield potential and the fact that "as the yield curve normalizes when the Fed cuts, we think that shorter yields will come down."
Norton is actively seeking yield within the muni market that can also be resilient in an economic downturn. He believes that multifamily affordable housing and charter schools offer promising options. However, he cautions investors to remain flexible. "Your portfolio today may not be the same way that it should look three months from now, after the election or after the Fed cuts, and so we recommend being active and being very flexible in the way you manage municipal bond portfolios," Norton said.
The Bottom Line: A compelling Opportunity for Investors
With strong fundamentals and attractive yields, municipal bonds appear poised to benefit from the expected interest rate cuts and potential for increased tax advantages. Experts recommend strategic portfolio positioning, focusing on investment-grade munis with shorter durations, taking advantage of the upward-sloping yield curve, and seeking out resilient sectors like multifamily affordable housing and charter schools. While the upcoming election introduces uncertainty, careful consideration of the potential tax implications and a flexible investment approach are key to navigating this dynamic market. With a good understanding of these factors, investors may find themselves in a compelling position to capitalize on the opportunities presented by municipal bonds.
