The tax-free municipal bond market continued to put on a heck of a show during the first quarter of 2024. Where US Treasury yields have risen since the end of the year, Muni bond yields have moved little and yield ratios are similar to year-end.
Here is the comparison of the US Treasury market compared to the corresponding AAA tax-free yield at year-end 2023.
Here is the same comparison from the end of business on March 22nd of this year.
As you can tell, muni/treasury yield ratios have remained low across the yield curve.
We believe the richness of the Muni market is a function of a number of factors.
• We have not seen bond fund liquidations during the quarter on a large scale (monthly inflow numbers as of 2/29 would be $6.07 billion), and the higher yields in Munis that carried over from last year have produced larger demand in the separately managed account area.
• Supply has not been a factor. In fact, supply is running ahead of last year (monthly issuance for Jan and Feb this year totals $58.57 billion, 28.05% higher than Jan and Feb of 2023 [$45.74 billion]). But demand has been voracious, with many tax-free deals seeing oversubscriptions, often 6–8x or higher.
• In normal markets (and we have had far from normal markets since the start of Covid), tax-free yields usually tighten to Treasuries in a rising-interest-rate environment. This is because of the tax exemption. So, for example, if the average marginal tax rate of the investing public is 25%, it suggests that Muni yields should only move up about 75% of a corresponding Treasury yield to produce the same increase in taxable equivalent yield. But this has been extraordinary tightening.
• One of our thoughts is that the lowering of yield ratios, particularly in the belly of the yield curve, is due to investors locking in yields, even at rates which almost appear to be so low as to suggest buying corporates or agencies and paying the federal tax and coming out better than the Muni yield. This suggests to us that investors are expecting a change in the White House, or Congress, or both. In other words, a change in tax policy coming out of the elections, and they want to lock in Muni yields now. Remember, without an act of Congress, the provisions of the tax bill of 2017 will sunset, including current tax rates (going higher), and SALT provisions (no cap on deductibility of state income taxes or local property taxes) returning to 2017 levels. This may also bring some investors back into the alternative minimum tax. So, for all the uncertainty, investors want to be committed to tax-free bonds NOW, and favor the short to intermediate maturities (which of course means the longer end presents more value).
• But another thought is that investors are not overbuying on Munis as much as they are fading Treasuries. Going back to last year, there are a number of factors which suggest that Treasuries (which are the most liquid instruments in the world) are not in as much favor as a few years ago. We had the downgrade by Fitch Ratings last year dropping the rating on US debt from AAA to AA+. Then, there have been vast amounts of Treasury supply. But the other overhangs are the huge budget deficits, as well as the huge bill for the interest on that debt. Interest expense is now higher than our spending on defense. Higher RELATIVE Treasury yields could be investors telling Congress to quit fighting and be constructive towards more responsible spending.
We hope all our readers enjoy the long weekend and we bid a hearty hello to the return of baseball.
John R. Mousseau, CFA
Chief Executive Officer & Director of Fixed Income
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