Municipal bonds rally with Treasuries, as central bank comments turn dovish

Municipal bonds rally with Treasuries, as central bank comments turn dovish

Q4 2023 Putnam Municipal Bond Funds Q&A

How did municipal bonds perform during the fourth quarter of 2023?

Global markets ended 2023 with strong returns across the board, as market participants reacted positively to more dovish central bank rhetoric, particularly from the Federal Reserve. Treasury yields rallied meaningfully across the curve into year-end, and municipal bonds moved in sync with this Treasury rally. Long-term municipal bonds outperformed their short-term counterparts. The Bloomberg Municipal Bond Index posted a total return of 7.9% during the fourth quarter. For 2023, the Bloomberg Municipal Index was up 6.4%, while the high-yield municipal index ended the year up 9.2%.

What is your current assessment of the health of the municipal bond market?

Fundamentals continue to be generally stable across most municipal sectors, but we also believe security selection and sector exposure matters in this environment.

Tax receipts for state and local governments fell 7% in the first half of 2023 compared with the same time period a year earlier. This decline primarily came from the effects of the inflated 2022 base of comparison. Also, capital gains tax receipts were lower due to weaker market performance. Viewed from a longer term perspective, overall state and local tax revenues remain 17% above their five-year average through Q3 2023.

Muni defaults in 2023 ran 20% below the previous 5-year average. Defaults remain low and are generally contained in the non-rated subsector. We would note that even during recessions, state and local tax revenue performance is resilient. We believe the muni sector is better positioned for a recession than it has been in previous economic cycles due to unprecedented levels of reserves.

In 2023, $29 billion flowed out of municipal bond mutual funds. While the category was still in outflows during the year, the pace moderated from 2022’s record levels. At the end of 2023, new issue supply was down 3% year over year. In our view, seasonal technical conditions have generally remained constructive into early January.

The taxable equivalent yield (TEY) of the Bloomberg Municipal Bond Index ended the year at 5.43%. Yields have rallied significantly since the end of October, while still remaining somewhat attractive on a long-term basis. AAA Muni/U.S. Treasury ratios, a commonly used valuation metric, ended the year richer on both a short- and longer-term basis. Long-maturity (30-year) ratios remained the cheapest cohort. At the same time, we believe the muni-Treasury ratios do not tell the entire story as credit spreads, even for highly rated AA bonds, are attractive. We feel the spreads for bonds rated AA, A, and BBB continue to represent the best opportunities in the municipal market.

What is your investment strategy for early 2024?

While the funds have an emphasis on investment-grade bonds, they can invest across the entire municipal landscape, including high-yield bonds, to leverage Putnam’s municipal credit research expertise. We continue to see value in the lower tiers of investment grade — A and BBB — as well as the higher tiers within high yield. In contrast, we are more cautious on lower rated cohorts and are currently not adding significantly to high yield.

In terms of interest-rate risk, we are targeting a modestly long duration position across our strategies, but it is important to emphasize that we slightly shortened our previous duration positioning in late December and early January. We recognized how far the market ran during the recent November and December 2023 rally. Compared to each funds’ peer group, the portfolios remain modestly long duration, as we believe interest rates will likely fall further as the Fed’s posture turns from restrictive to accommodative.

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