Municipal Outlook 2024: Capture the Momentum

Falling Rates Ahead

The Fed left its benchmark fed funds rate unchanged in December, citing more victories in its war on inflation. Without committing to a concrete pivot, policymakers hinted of up to three possible cuts in 2024.

Once they start, Fed easing cycles tend to move much faster than hiking cycles. For example, rising-rate periods have historically averaged 10.1 months, subsequent pauses about four months, and easing cycles just 7.6 months. Moreover, munis significantly outperformed T-bills after taxes over the 12 months following rate pauses (Display). With the Fed already in pause mode today, we think it’s time for investors to get off the sidelines and back in the market—and soon.

Historical analysis does not guarantee future results.
*Municipal returns are for the Bloomberg Municipal Bond Index. T-bill returns are for the ICE BofA US 3M Treasury Bill TR USD. Assumes a tax rate of 40.8%. Data represent average returns for the 12 months following Fed rate-hike pauses on the following dates: September 1, 1984, October 1, 1987, March 1, 1989, March 1, 1995, June 1, 2000, July 1, 2006, and January 1, 2019.
Through December 31, 2023
Source: Bloomberg, Federal Reserve, J.P. Morgan and AllianceBernstein (AB)

Muni Market’s Time to Shine

Even after their extended rally since late October, munis have considerably more room to run, in our analysis. Given current yields, munis should continue to outperform three-month Treasuries on an after-tax basis if interest rates simply stay where they are.

Municipal bond return potential looks even brighter if yields decline as we expect. If Treasury yields fall from current highs, we expect munis to benefit, thanks to the inverse relationship between yield and price.

For instance, even a decline of 50 basis points (bps) in Treasury yields over the next year could net a nearly 2% price gain for munis, for an expected total return of about 5.0%; a full 100 bps decline in Treasury yields would boost muni total returns to 6.9%. By contrast, Treasury yields would have to rise a full percentage point—an unlikely scenario in today’s economic environment—for municipal bond prices to fall far enough to offset their ample yield cushion (Display).

For illustrative purposes only. Current analysis does not guarantee future results.
Simplified illustration based on total return components over 12 months and subject to change
*Implies a 60% beta sensitivity of municipal yields to US Treasury yields
As of December 31, 2023
Source: Bloomberg, Morningstar and AB

Muni Strategies Tailor-Made for 2024

In our view, today’s backdrop raises the question: What are investors waiting for? In this environment, several strategies can be effective for getting the most out of your munis.

Extend your duration target. Longer duration will be especially beneficial to bond prices if yields head lower in 2024, as we expect them to.

Consider a barbell maturity structure. Although there’s no all-weather maturity-structure strategy, in the current environment a barbell can harness today’s inverted yield curve without increasing interest-rate risk. For instance, investing in one- and 15-year munis in equal amounts currently yields more than an eight-year bond, but with the same sensitivity to interest-rate changes.

Look to muni credit. These include BBB-rated bonds, which offer significantly more yield than higher-rated issues. This spread has widened slightly in recent months and remains compelling compared to long-term averages. Be selective with credit, however, since issuer fundamentals can vary.

Headlines have suggested a fiscally cloudy picture for many states and cities, whose tax revenues have been strained. But muni issuers overall are in their best financial health in decades. While we don’t currently expect a recession, we believe states are recession ready. They’re also inherently resilient to fiscal challenges, which is why muni issuers have rarely defaulted.

Stay flexible. Given the significant rally in municipal bonds, muni investors should consider rotating into US Treasuries, as certain maturities offer an after-tax yield advantage over comparable munis. Since the relationship between munis and Treasuries is highly variable, be ready to toggle back when munis again cheapen relative to Treasuries.

Municipal bonds have had a strong run lately, but there’s still a lot left in the tank. Though there’s rarely a perfect time to invest, today’s high yields, along with expectations of a soft landing and rate cuts, make for a timely opportunity for long-term municipal bond investors.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.