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Performance Review
The municipal (muni) bond market, as measured by the Bloomberg Municipal Bond Index, recorded modest negative total returns for the second quarter of 2024 and fared worse than duration-matched US Treasuries (USTs), witnessing negative excess returns. The period saw investor sentiment oscillate between caution in light of hawkish US Federal Reserve (Fed) comments and optimism as disinflation was seen to resume in April and May. The Fed kept its policy rate unchanged during the period—despite the two softer inflation prints—and revised its median rate projections to show just one rate cut in 2024. Against this backdrop, demand for muni bonds was robust throughout the quarter, even in the face of increased new tax-exempt bond supply, as it seemed that many issuers were trying to finalize bond sales before potentially heightened volatility ahead of the US presidential election. Revenue-related issues recorded positive absolute returns and outperformed general obligation ('GO') bonds during the period. From a ratings standpoint, lower-rated securities outperformed their higher-quality counterparts as spreads across lower-rated cohorts have continued to narrow this year.
Quarterly Key Performance Drivers
Duration | Quality | |
HELPED | Underweight Municipal Bonds with Two to Five Years to Maturity | Overweight Bonds with No External Credit Rating |
— | Security Selection in AA Rated Bonds | |
— | Security Selection in BBB Rated Bonds | |
HURT | Overweight Municipal Bonds with 20 or More Years to Maturity | — |
— | — | |
— | — |
Overall, duration positioning modestly detracted from relative fund performance during the second quarter. Yields increased across most maturities, and therefore our overweight to muni bonds with 20 or more years to maturity hurt relative returns. However, an underweight to muni bonds with two to five years to maturity lifted results. Rating allocations boosted relative fund performance for the period, led by our overweight to bonds with no external credit rating. Security selection among rating categories, particularly in AA and BBB rated bonds, also added to relative returns.
One-Month Key Performance Drivers
Duration | Quality | |
HELPED | Overweight Municipal Bonds with 20 or More Years to Maturity | Overweight Bonds Rated Below Investment Grade |
— | Overweight Bonds with No External Credit Rating | |
— | Security Selection in BBB Rated Bonds | |
HURT | Underweight Municipal Bonds with Two to 10 Years to Maturity | Security Selection in A Rated Bonds |
— | Security Selection in AA Rated Bonds | |
— | Security Selection in AAA Rated Bonds |
Duration positioning supported relative fund performance in June. Our overweight to muni bonds with 20 or more years to maturity helped returns as yields declined across much of the curve. This was only partly offset by an underweight to bonds with two to 10 years to maturity, which curbed results.
Rating allocations also contributed to relative fund performance for the month, driven by overweights to bonds rated below investment grade and those with no external credit rating. Security selection among rating categories, particularly in A, AA and AAA rated issues, detracted from returns. In contrast, selection in BBB rated securities added to results.
Outlook & Strategy
Financial market sentiment was mixed throughout the quarter. The start of the period saw persistent price pressures and a relatively hawkish stance from the Fed. However, sentiment improved somewhat with two softer inflation prints and data that pointed to a weakening US economy, which was seen to support the possibility of earlier Fed rate cuts. This mixed picture weighed on tax-free muni bond performance during the quarter. Nevertheless, technical supply/demand conditions were positive, as new issuance was robust and fund inflows positive. Anecdotal evidence suggests that this trend may continue, as asset allocators still retain high cash and cash-equivalent balances that they are starting to re-allocate to the sector, and especially if compelling opportunities should arise. Muni bond yields remain at historically elevated levels and can be particularly appealing for those investors who target tax-adjusted yields. A major catalyst that we are looking at for inflows to pick up more significantly is the flattening of the UST yield curve inversion and a return to its typical, upward sloping shape. Going forward, declining yields (when the Fed begins to ease monetary policy) should provide a tailwind for bond investors in 2024.
Fundamentals in the muni market remain stable and should be supportive of the asset class over the medium to long term. We have likely reached the peak of the credit cycle, which saw rating upgrades significantly outpace downgrades. Going forward, the credit environment is set to normalize over the next year or more, though continued economic stability and improved financial positions should defend against any sharper deterioration. State and local governments have many tools to address potential challenges, particularly as they still retain large “rainy-day” funds that were bolstered by federal COVID-19 aid, increased during the pandemic recovery, and maintained with conservative budgeting and fiscal discipline. Nevertheless, a disciplined fiscal approach will remain crucial to deal with slower revenue growth, the runoff of COVID-related aid, rising expenses and higher borrowing costs. While we are not worried about a spike in defaults, worsening macroeconomic conditions will mean that rigorous bottom- up research and strong security selection will be particularly important in finding those credits that have the potential to outperform across market cycles.
In the United States, while the economy continues to show signs of resilience, we see growth risks on the rise. At the same time, upside risks to inflation are far from abated. There are signs of consumer weakness, as real disposable income per capita has stagnated over the past year, and recent company earnings reports point to consumers prioritizing essential over discretionary spending. Additionally, though household wealth has remained resilient, the labor market is normalizing from its recent tight levels, with employees growing cautious about their job prospects. In terms of inflation, we see idiosyncratic factors and catch-up effects driving the core measure in particular. The Fed will continue to look for evidence of a sustained move lower in inflation before it can embark on monetary policy easing. This, in turn, can cause some spread volatility over the near term. It is our view that these instances can potentially provide an attractive entry point into the tax-exempt muni bond market. We believe there are opportunities to find value within the sector across the credit spectrum.
| Fund Details
Fund Description The fund seeks to provide investors with as high a level of income exempt from regular federal income taxes as is consistent with prudent investment management and the preservation of shareholders’ capital.1 Performance Data: Average Annual Total Returns2,3(%)
The Bloomberg Municipal Bond Index is a broad measure of the municipal bond market with maturities of at least one year. Source: Bloomberg Indices. 1.Dividends are generally subject to state and local taxes, if any. For investors subject to the alternative minimum tax, a small portion of fund dividends may be taxable. Distributions of capital gains are generally taxable. 2.Periods shorter than one year are shown as cumulative total returns. 3.Since inception return for the benchmark is calculated to the fund inception date. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
