With the Federal Reserve rate-cutting cycle expected to begin and the November election just around the corner, now could be a good time to invest in municipal bonds. For one, they are a way to lock in yield as interest rates fall. "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 is a measurement of a bond's price sensitivity to fluctuations in rates, and longer-dated issues tend to 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. Interest earned on municipal bonds are free from federal tax.
They may also be exempt from state taxes if the investor resides in the issuing state. On top of that, issuers have been adding more supply to the market, but that is expected to slow by Election Day, at least in the primary market, said Dan Close, head of municipals at Nuveen. "Buying now, when there's a lot of paper and it's cheaper, we think presents an opportunity," he said.
Plus, "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." The election is bringing a lot of uncertainty about what will happen with the expected expiration of tax cuts at the end of 2025. Close said he is already seeing financial advisors start to position their muni portfolios in anticipation of changes.
If there is a dividend government or a Democratic sweep of both the White House and Congress, there is the potential for "meaningfully higher taxes," he said. "It's just going to be really, really tough to go in to pass comprehensive tax reform," he said. However, Paul Malloy, head of U.
S. municipals at Vanguard, suggests looking through the "noise" when it comes to the election. While a lot of proposals are thrown out on the campaign trail, things can change during the act of governing, he said.
"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. What tax changes mean Absent any congressional action, certain provisions in the Tax Cuts and Jobs Act, or TCJA, will sunset at the end of next year . That means that the once-lowered federal income tax brackets will revert higher, 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 instance, a muni bond yielding 5% has a taxable equivalent yield around 7.
9% right now, he said. With the new tax rate, that taxable equivalent yield goes to 8.25%, he said.
Also on the table is the alternative minimum tax, or AMT, which is a tax individuals have to pay if their income exceeds certain thresholds. Under the TJCA, the number of people paying the tax was about 200,000, Close said. That could balloon to 7.
6 million if the legislation sunsets, he said. "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," he said.
Therefore, Close is taking a look at private activity bonds, primarily airport and housing bonds, that 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?'" In addition, the $10,000 limit on the federal deduction for state and local taxes, known as SALT, will expire. That impacts high-tax states like California, New York and New Jersey.
"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." How to position portfolios Right now, fundamentals and yields are at the highest they've been in decades, Vanguard's Malloy said.
"Municipals are very much part of the 'bonds are back' story," he said. "On top of having really great credit fundamentals, as we get to more end-of-cycle dynamics, municipalities pay you to wait and provide ballast if we do turn into a slower economic scenario." He specifically likes investment-grade munis.
Those rated A and BBB that have durations of 10 years or less are the most attractive right now, while bonds rated AAA and AA are looking a little rich, Malloy said. Nuveen's Close likes A, BBB and below investment-grade munis. The fundamentals are favorable as state and local governments have record amounts of cash on their balance sheets, he said.
Plus, the technicals are good, he added. "These bonds still have room for credit spread compression," Close said. "Given the fundamentals, we think that given the lack of issuance for higher yield and paper, it's just created a very positive technical.
" Unlike the Treasury market, the muni market yield curve is upward sloping, Close said. Therefore he favors a barbell strategy when it comes to duration. One strategy at the firm focuses on the zero to two-year part of the curve and barbells it with the 15-year part of the curve, he said.
"You are getting paid to take duration risk," Close said. At AllianceBernstein, there are a number of things the team is doing across their portfolios, Norton said. For one, the team is taking on more interest rate risk than it typically does, since munis are attractive on a relative basis and interest rates are likely to fall, he said.
Plus, munis will see heavy inflows as investors start to move out of cash , he said. Some $6.3 trillion is currently sitting in money market funds, according to the Investment Company Institute .
In addition, there's room for lower-rated municipalities to outperform, such as A, BBB and high yield, Norton said. "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," he said. Norton also likes a barbell strategy, with one year and 15- to 20-year bonds.
"It provides more yield, and it also, we think, will reduce the risk of portfolios, because as the yield curve normalizes when the Fed cuts, we think that shorter yields will come down," he said. With most parts of the muni bond market pretty strong from a credit perspective, Norton is trying to find yield that can also be resilient in an economic turndown. That means multifamily affordable housing and charter schools .
That said, investors should remain nimble, said Norton. "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," he said..
