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MARKETS
27 February 2024

Weekly Municipal Monitor—Taxable Relative Value Persists Amid Dwindling Supply

By Sam Weitzman
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Municipals Posted Positive Returns Last Week

Munis posted positive returns but generally underperformed Treasuries, as the Treasury curve flattened during the week. High-grade muni yields were generally unchanged during the week, moving just 2 bps lower in 5-year maturities. Meanwhile, technicals were mixed as modest fund outflows were offset by lower new-issue supply levels. The Bloomberg Municipal Index returned 0.15% during the week, the High Yield Muni Index returned 0.42% and the Taxable Muni Index returned 0.34%. This week we highlight the deteriorating supply trends in the taxable muni market.

Modest Fund Outflows Were Largely Offset by Lighter Supply Conditions

Fund Flows: During the week ending February 21, weekly reporting municipal mutual funds recorded $4 million of net outflows, according to Lipper. Long-term funds recorded $406 million of outflows, high-yield funds recorded $403 million of inflows, intermediate funds recorded $296 million of outflows and short-term funds posted outflows of $95 million. This week’s outflows lead estimated year-to-date (YTD) net inflows lower to $3.3 billion.

Supply: The muni market recorded $5.4 billion of new-issue volume last week, up 5% from the prior week. YTD issuance of $55 billion is 47% higher than last year’s level, with tax-exempt issuance 49% higher and taxable issuance 17% higher year-over-year (YoY). This week’s calendar is expected to increase to $6 billion. The largest deals include $1.2 billion New York City General Obligation and $600 million Hurst-Euless-Bedford Independent School District transactions.

This Week in Munis: Taxable Relative Value Persists Amid Dwindling Supply

The municipal market observed a wave of taxable new issuance in the years that followed the 2017 Tax Cuts and Jobs Act, as the law prohibited the advanced refunding (refinancing) of tax-exempt issuance with new tax-exempt debt. From 2018 to 2021 taxable municipal market yields were generally lower than originally issued tax-exempt yields, and municipal issuers were able to utilize the taxable municipal market to refinance outstanding debt. As a result, taxable municipal issuance multiplied from $40 billion (12% of total municipal issuance) in 2018 to as high as $182 billion (37% of issuance) in 2020 and $138 billion (29% of issuance) in 2021.

Exhibit 1: Taxable Municipal Issuance as a Percent of Total Issuance
Taxable Municipal Issuance as a Percent of Total Issuance
Source: Bloomberg, Western Asset. As of 20 Feb 24. Select the image to expand the view.

As interest rates moved higher in 2022, the favorable economics of refinancing muni debt deteriorated and taxable municipal issuance declined materially. In 2023, taxable municipal issuance declined 80% from the high watermark set in 2020 to $38 billion, a below-average 10% of total issuance. The declining trend continued so far in 2024, with $3 billion of taxable municipal issuance YTD comprising just 6% of total issuance.

The effect of lower taxable new-issue supply has been more recently compounded by increased tender and redemption activity, where states and cities can redeem outstanding debt. As municipal-to-Treasury ratios approach near-record lows, the tax-exempt market has become relatively appealing to municipal issuers, accelerating taxable market redemptions. Declining new taxable supply levels, coupled with these increasing redemptions have contributed to negative net taxable supply levels of nearly -$100 billion since the start of 2022.

The strong supply technicals have supported the strong performance of the taxable municipal market as well as relative spread compression. However, limited liquidity of the asset class and recent corporate spread-tightening have still contributed to an appealing relative value proposition for investors seeking high-quality, longer-duration bonds. Over 75% of the Bloomberg Taxable Municipal Index is rated AA and higher, and index yields highlight a 9- to 37-bp yield advantage versus the Bloomberg US Corporate Index, which Western Asset deems as an appealing relative value proposition.

Exhibit 2: Taxable Munis vs. Corporate Index Credit Compositions and Yields
Taxable Munis vs. Corporate Index Credit Compositions and Yields
Source: Bloomberg, Western Asset. As of 20 Feb 24. Yield-to-worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. Bloomberg Composite Rating of the Bloomberg Taxable Municipal Bond Index vs. the Bloomberg US Corporate Index. Select the image to expand the view.

Municipal Credit Curves and Relative Value

Exhibit 3: Muni Credit Curves
Muni Credit Curves
Source: Bloomberg, Western Asset. As of 23 Feb 24. Bloomberg BVAL Municipal Credit Indices (AAA, AA, A, BBB, respectively) and US Sovereign Curves. Taxable-Equivalent Muni Credit Curves consider the top marginal effective tax rate of 40.8%. Select the image to expand the view.
Exhibit 4: Taxable-Equivalent Muni Credit Curves
Taxable-Equivalent Muni Credit Curves
Source: Bloomberg, Western Asset. As of 23 Feb 24. Bloomberg BVAL Municipal Credit Indices (AAA, AA, A, BBB, respectively) and US Sovereign Curves. Taxable-Equivalent Muni Credit Curves consider the top marginal effective tax rate of 40.8%. Select the image to expand the view.
Exhibit 5: AAA Munis versus Treasuries
AAA Munis versus Treasuries
Source: Bloomberg. As of 23 Feb 24. Past performance is not a guarantee of future results. It is not possible to invest directly in an Index. Select the image to expand the view.
Exhibit 6: Tax-Exempt and Taxable Muni Valuations
Tax-Exempt and Taxable Muni Valuations
Source: Bloomberg. As of 23 Feb 24. Select the image to expand the view.

Western Asset Key Themes for Muni Investors

Theme #1: Municipal taxable-equivalent yields are above decade averages.

Exhibit 7: Muni and Taxable-Equivalent Muni Yield-to-Worst
Muni and Taxable-Equivalent Muni Yield-to-Worst
Source: Bloomberg, Western Asset. As of 23 Feb 24. Bloomberg Municipal Bond Index Yield Considering Highest Marginal Tax Rate. Select the image to expand the view.

Theme #2: Recent yield curve steepening has highlighted relative value in longer maturities.

Exhibit 8: AAA Municipal vs. Treasury Yield Curves
AAA Municipal vs. Treasury Yield Curves
Source: Bloomberg, Western Asset. As of 23 Feb 24. Bloomberg BVAL AAA Muni Curve and US On-/Off-the-Run Sovereign Curve. Select the image to expand the view.

Theme #3: Munis offer attractive after-tax yield pickup versus long Treasuries and corporate credit.

Exhibit 9: Municipal vs. Taxable Fixed-Income Yields by Quality
Municipal vs. Taxable Fixed-Income Yields by Quality
Source: Western Asset, Bloomberg. As 23 Feb 24. Bloomberg BVAL AAA Muni Curve and US On-/Off-the-Run Sovereign Curve. After-tax yield considers top marginal tax rate of 40.8%. Select the image to expand the view.

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