CONTRIBUTORS
Jennifer Johnston
Director of Research, Municipal Bonds,
Franklin Templeton Fixed Income
The tax-exempt municipal (muni) bond market is entering the new year on a strong note—credit fundamentals are stable and the macroeconomic backdrop supportive. However, we see pockets of weakness, which means that thorough security selection remains crucial going forward.
Fundamentals remain healthy…
It appears that the US Federal Reserve (Fed) has managed to achieve the much-hoped-for “soft landing.” Sustained disinflation has meant that the cost pressures facing muni issuers have eased. However, elevated inflation translated into higher tax receipts, so as the former has declined, we have also seen revenue growth moderate.
Healthy economic growth (and federal COVID-19 aid) has allowed many muni issuers to bolster their reserves, making them well positioned to deal with any potential challenges that may arise. Therefore, if revenue growth does not keep up with expenses, issuers can tap their reserves (illustrated in Exhibit 1) or use a variety of other budget tools—for example, revenue increases and cost cutting measures—to help them manage potential budget deficits.
Exhibit 1: Total State “Rainy Day Fund” Balances Remain Elevated
Sources: National Association of State Budget Officers (NASBO), Fiscal Survey of States. As of June 28, 2024.
January marks the beginning of “budget season” for many state and local governments, which we will be watching closely. Proposed budgets can give us insights into issuers’ fiscal positions and information on funding for various other entities, such as public education or health care providers.
… but there are areas of concern
The muni market as a whole continues to exhibit strength, which is reflected in a 15-quarter streak of credit rating upgrades outpacing downgrades (illustrated in Exhibit 2).1
Exhibit 2: Total Credit Rating Upgrades Versus Downgrades in the Muni Market
Sources: Credit rating agencies Moody’s and S&P. As of September 30, 2024.
Private higher education and health care are two sectors that are bucking the trend, with a negative upgrade to downgrade ratio. The former is becoming bifurcated, with larger universities continuing to draw students, while smaller, regional colleges are struggling. Meanwhile, health care providers saw significant cost pressures coming out of the pandemic, as they dealt with increasing wages and labor shortages. However, moderating inflation and a normalizing job market helped hospitals and care facilities improve their financial positions.
The technical backdrop appears constructive
We expect demand for munis to remain robust in 2025. With the Fed lowering interest rates—albeit cautiously—investors will likely be enticed to leave the recently popular money market instruments in a search for yield. Yields are elevated versus historical levels, offering the potential for attractive fixed income. This is particularly true when one considers these yields on a tax-adjusted basis (for those investors who can take advantage of tax exemptions) and in conjunction with the sector’s high credit quality. For an additional yield pickup, we especially like longer-dated bonds and lower-rated securities.
Conclusion
It is our conviction that even within areas the sector that are challenged, compelling investment opportunities may still exist—it just means that security selection becomes crucial. We therefore apply our robust, bottom-up research to the complex muni bond landscape in order to find those issuers that appear most promising to us. Given the strong fundamentals, attractive valuations, and positive outlook for technical, we remain generally optimistic about the muni market going into 2025.
Endnote
- Source: Credit rating agencies Moody’s and S&P. As of September 30, 2024.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Alternative Minimum Tax, and state and local taxes may apply.