A Macro View Of The Muni Market As 2024 Gets Underway

Main Thesis/Background

The purpose of this article is to discuss the current macro-environment of the market right now, with a specific focus on the implications for tax-exempt municipal ((muni)) bonds. This is top of mind for me for a few reasons. One, the bond market as a whole (including munis) had a rather volatile 2023 that included a surge higher in the final stages of the year. This, at the very least, warrants some examination.

Two, equity markets are very complacent to a number of headline risks and are getting extremely concentrated by the rise in the “Magnificent 7”. This suggests to me that diversification – either through other equity positions or through hedges like munis – make a lot of sense right now. Three, the Fed continues to cause a lot of yield volatility in the treasury market. This complicates the outlook for bonds and warrants close monitoring in the months ahead.

In this review, I will explain why I continue to view the muni sector positively. I see a lot of merit to building (or initiating) positions at these levels – primarily for high-income investors and/or those who anticipate some level of correction in the equity market. I will dig into the reasons behind my sentiment, as well as some options to choose to enter this sector.

Equity Optimism Suggests A Place For Hedges

To begin I will take a moment to discuss some of the reasons why readers may want to consider munis now. As my followers know, this has been a long-term sector allocation of mine as a working professional in a higher income tax bracket. So I see merit to this exposure in most cycles (minus when the Fed is embarking on an aggressive rate-hiking cycle!). But this may not be the case for everyone depending on their individual circumstances. Nevertheless, there are legitimate reasons for giving this sector consideration at the moment.

One reason in particular is the bullishness in the equity market. While munis are unrelated to equities – that is precisely the point! They often serve as an equity hedge, performing well on down days and vice versa. This can help protect investors from upcoming volatility and/or losses in the equity market, and help balance out an equity-heavy portfolio – such as my own.

To support why I feel equity levels as a whole are stretched, we can examine a number of different metrics. But one in particular that is striking to me is what is going on in the futures market. Asset manager’s positioning in equities suggests the highest long-equity stance in nearly two years:

If that doesn’t shout “euphoria”, I’m not sure what does. Of concern, consider that in mid and late-2021 is where positioning was this high. We all know how large-cap US stocks performed in 2022 (hint: poorly).

This is just one reason why I believe equity hedges have some value here. Equity markets are stretched and if earnings don’t keep up a lot of downside may be ahead.

Why Munis? State and Local Governments In Decent Fiscal Shape

While I discussed in the prior paragraph that I have concerns with equity levels – as measured through the S&P 500 – that doesn’t automatically make munis a buy. There are plenty of other ways to hedge equity risk. One is non-US stocks. Another is cash. A third that is most relevant to this discussion in corporate or treasury bonds. Muni bonds are just one area of the fixed-income market. This makes it important to examine how attractive they are relative to other income options before diving in.

In this respect, I see value in munis in relative terms. While the federal government and corporations – both highly rated and junk-rated – have binged on debt in the past decade, state and local governments have not. This is due to a number of factors, namely of which they cannot borrow and spend the way the Feds can. The net result is that state and local governments currently have less debt – as debt levels have risen modestly while levels for households, the federal government, and US corporations have seen debt levels surge by comparison:

What this suggests to me is that state and local governments are in decent shape to kick-off the 2024 calendar year. They aren’t facing the same high burden of debt levels, and that suggests to me the forward outlook is a little less cloudy.

This is important in my view, especially for those who want to move down the credit ladder and into high yield securities. I personally own high yield muni exposure and I prefer it to below-IG rated corporate debt. One reason is due to the tax-exemption, but the other is that cracks in the corporate sector tend to appear first, before reaching the muni market. So I prefer to capitalize on high yields in the safer muni sector as a result – and that has served me well over time.

I think this is definitely a point to emphasize for the time being. This is because there are some cracks emerging at this very moment. Within the junk-rated corporate bond sector, loan recoveries have been on a sharp decline in 2023. This means that when a borrower is in distress or enters bankruptcy proceedings, the percentage of the loan that the lender ultimately recovers has been dropping:

This results in higher losses for lenders and, ultimately, the investors in those securities. Given the dramatic shift in this figure, I’m not optimistic it will suddenly improve just because the calendar reads “2024”. I see this weakness and historical low level of recoveries as further support that investing in munis, at the expense of corporates, is the right move to make.

**I own the VanEck High Yield Muni ETF (HYD).

Income Stream Is Historically Elevated

Beyond credit quality, another reason for considering munis is the income stream. While munis (as a whole) participated in the Q4 rally that has resulted in pushing current yields down a bit, they remain historically elevated when compared to the prior fifteen years:

As you can see, when looking at both absolute yields and tax-adjusted yields for the higher tax brackets, investors in munis can earn upwards of 5.5%. That is fairly appealing, especially as inflation has come down and the Fed has not suggested any more rate hikes are on the way in the near term – with the possibility of cuts at some point in 2024 to be the more likely scenario.

I will note that there doesn’t appear to be a whole lot of urgency to lock in these yields, given the Fed has poured cold water on a March rate cut (and suggested a more hawkish path in 2024 than the market is hoping for). I say this because I don’t want readers to “panic buy” this sector now – or any other fixed-income sector – because the opportunity could be around for a while.

But the flip-side of that is the market can move fast. Q4 showed us how beaten-down sectors can rebound swiftly and I would advocate getting your ducks in a row to move on this opportunity in the short-term. I personally have some muni exposure and will be adding to it over the next few months because the reality is that treasury yields will probably end the year lower, not higher. This means throughout the first half of 2024, people probably want to be buying this sector, rather than selling or avoiding.

**In addition to HYD, I am buying individual issues from my home state of North Carolina that are primarily transportation and GO-focused. I continue to recommend readers find tax-exempt munis in their home state for the biggest tax advantages.

Risks and Trends To Keep An Eye On

As with any stock, fund, or thematic idea I have, I will take some time to discuss the risks. Paramount for the muni space – especially in the high -ield corner – is credit quality. I discussed earlier how I believe credit worthiness is stronger in munis than corporates (treasuries are certainly the safest, but munis yield more). I don’t see any reason why munis will experience more defaults than corporates this year. That is almost never the case and corporate bonds have plenty of their own headwinds to contend with.

But that doesn’t mean munis are “risk free”. In particular, readers should understand that when defaults occur in this sector, they tend to be concentrated in the Health Care/Health Services sub-sector. This has been the trend for certainly the past decade, and mostly notable in the last five years. The reason is straightforward: unlike GO-bonds, issues from health care providers or hospitals only have revenues as a source of repayment. This makes these bonds riskier than bonds issued by states or local governments, or even revenue sources that have the ability to raise through revenue through higher use fees (i.e. toll road increasing what they charge).

The impact of this is significant. When defaults do occur in this broader sector, they are overwhelmingly concentrated in health-related arenas. This is a critical risk investors need to evaluate before buying any muni fund or individual issue:

I bring this up because many CEFs exist for munis and they are a popular way to place this space. Given the use of leverage, yields can be quite attractive. Further, many CEFs from well-known shops like PIMCO, BlackRock (BLK), and Nuveen have a plethora of funds trading at discounts (sometimes substantial discounts) to NAV. This can attract value-oriented buyers.

But my concern is if people buy these funds without really understanding what is in them. A fund could have a double-digit discount to NAV, for example, for a good reason. Perhaps it is heavily allocated to health-related bonds that are teetering and may default. Or perhaps the issues are not rated at all, creating a lack of transparency behind how risky this particular fund is. I use muni CEFs myself, so this is not an overall knock on this investment idea. But I am using this space to suggest readers dig carefully into the holdings of any fund they want to buy and to make sure one is not blinded by the yield or the valuation on the surface alone.

Another risk to consider is the muni sector has gotten more volatile than in decades past. For older investors, they may remember when munis were a boring, set-and-forget area. While it can still be that way, the last two years have seen an uptick in volatility in this space. As mentioned earlier, munis ended 2023 on a very strong note, but the first half of the year was pretty ugly. And 2022 saw some big swings too:

This is not meant to alarm. I stand by my call that munis offer some value here. But it would be naive to think it is going to be a straight shot higher. There has been quite a bit of volatility in the last few years and that doesn’t disappear overnight. So be sure to ladder in, know your own risk tolerance, and not to panic, but rather, to take advantage of the swings.

Bottom-line

The muni sector has been a primary component of my portfolio for a long time and I don’t see that changing in 2024. When I lightened up on my exposure last year, I see a much more favorable environment going forward and will be rebuilding my position. This is due to the potential for Fed rate cuts in the second half of the year (my prediction), a declining inflation environment, historically elevated yields for munis, and fiscal restraint by many state and local governments, relative to their corporate counterparts.

I personally think readers will be well-served by finding individual issues for GO bonds, transportation bonds, and utility-backed bonds in their home state. Aside from that, I see value in high yield muni ETFs, as well as CEFs that are not extensively leveraged and/or do not have too heavy of an allocation to health care systems or hospitals. I am hopeful readers will be able to profit off this sector in the year ahead.