What is the Economy Telling Muni Bond Investors?

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<h3>James A. Klotz</h3>

James A. Klotz

Have you tried to figure out what’s in store for the economy?

It’s an exercise many attempt but few, if any, succeed. Worse, for municipal bond investors, it can obscure what really matters.

To illustrate this, let’s take a snapshot of where we are today.

After 11 straight interest rate hikes beginning in March 2022, the Federal Reserve Board’s efforts to tame inflation have been somewhat successful; inflation is at a three-year low.

However, despite plans to begin lowering rates, the Fed hasn’t budged yet, as inflation has yet to reach its 2.00% target.

What is the economy telling muni bond investors

Hard landing? Soft landing? Have we landed?

Meantime, the U.S. economy shows encouraging signs. It added 353,000 jobs last month, about double what economists predicted, while the unemployment rate was 3.7% in January, a bit lower than the expected rate of 3.8%.

Consumer spending continues to grow. December’s retail sales reached $700.9 billion, a bump of 0.6% over November’s sales, and 5.65% higher than in December 2022.

Last year, the U.S. trade deficit fell to its lowest level in three years, though it inched up in December. Exports rose in December and in 2023 hit an all-time yearly high.

What are we to make of this information?

Maybe we are in the midst of a sought-after but difficult-to-achieve soft landing, where higher interest rates help cool inflation while unemployment doesn’t spike and GDP doesn’t dive.

Or perhaps we are headed for a full-blown recession. Maybe something in-between?

Who knows.

Treasury yield curve still inverted

The Treasury yield curve remains inverted, which usually presages a recession, but it’s been inverted since late 2022.

We can’t predict what’s next, and anyone who claims to have foreseen all the economic machinations of the past few years is fibbing.

What we can weigh in on is what’s actually happening in the municipal bond market, and that is encouraging.

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    Municipal bond yields are hovering near years-long highs.

    Analysts say the finances of issuers are strong, though there could be some headwinds this year.

    Demand for municipal bonds continues to outstrip supply, and there’s been a significant movement of buyers from muni funds to individual issues.

    Where we are now

    Beyond the massive amount of data and endless guesswork devoted to predicting where the economy is headed, and how fast, is a simple truth: We are in a particularly attractive market for municipal investors.

    “Credit quality remains strong across the broad array of muni sectors, absolute yields and attractive cashflows provide a compelling argument to put sidelined cash to work in a tax-efficient manner, better relative value opportunities support future investment performance even after the sharp advances on fixed income asset valuations late last year, and market technicals should bolster out-performance,” an Oppenheimer strategist said last month, according to The Bond Buyer. “Taxable equivalent yield calculations make the value proposition that much more apparent.”

    Given this scenario, it’s puzzling that some investors choose to remain on the sidelines with cash locked up in money-market funds.

    When we wrote about it last year (“Parking problem: How Muni Investors Lose Out”), money market assets were at about $4.82 trillion. Now, according to John Hancock, the figure has grown to almost $6 trillion, with $2.1 trillion more in CD balances in U.S. banks.

    It’s easy to get lost in the thicket of facts, figures and conjecture on what’s ahead in the markets – and it’s contrary to how and why we invest in municipal bonds. We can’t predict the future, and as part of an investment strategy, we don’t recommend trying it.

    What we do know is that the goal of muni investing is simple: Maintain a steady stream of tax-free income. Understand the bonds you’re buying, and get some help by conferring with a municipal bond specialist.

    Trying to accurately predict the future of the economy is complicated and futile. Generating tax-free income isn’t.

    James A. Klotz is the President of FMSbonds, Inc.
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    Feb 8, 2024

    Please note that all investing entails risk. Fixed income securities are subject to risks that will affect their value prior to maturity. Some of these risks can be related to changes in market conditions, issuer creditworthiness, and interest rates. This commentary is not a recommendation to buy or sell a specific security. All references to tax-free income refer to U.S. federal income tax. Income earned by certain investors may be subject to the Alternative Minimum Tax (AMT), and or taxation by state and local authorities. Please consult with your tax professional prior to investing. For more information on these topics please click on the “Bond Basics” link below or search by keyword at the top of this page.