Navigating the Muni Bond Landscape: Unlocking Yield and Weathering Tax Changes

As the Federal Reserve continues its rate-cutting cycle and the November election looms, now may be an opportune time for investors to explore municipal bonds. These tax-exempt securities offer a way to lock in yield as interest rates decline, and the potential changes in the tax landscape could further enhance their appeal. However, navigating the muni bond market requires a nuanced approach, as various factors, from the election's outcome to the expiration of certain tax provisions, could impact the landscape. This article delves into the strategies and considerations for positioning municipal bond portfolios in the current environment.

Unlocking Yield and Weathering Tax Changes in the Muni Bond Market

Capitalizing on the Fed's Rate Cuts

The Federal Reserve's rate-cutting cycle has created a favorable environment for municipal bonds. As interest rates fall, these longer-duration securities offer an attractive way to lock in yield. "Municipals are a great way to do that, given the tax-exempt nature, and given that a lot of municipals are longer maturity and longer duration," explains Matthew Norton, chief investment officer for municipal bonds at AllianceBernstein. With money expected to flow out of cash and into the muni market, Norton anticipates "an environment where municipals could meaningfully outperform."

Navigating the Tax Landscape

The upcoming expiration of certain provisions in the Tax Cuts and Jobs Act (TCJA) at the end of 2025 could have significant implications for the muni bond market. "That's actually very good news for municipals, because the municipal exemption just becomes worth that much more," says Dan Close, head of municipals at Nuveen. With the top federal income tax rate set to revert to 39.6% from 37%, the taxable equivalent yield on a 5% muni bond could rise from 7.9% to 8.25%.Additionally, the potential reinstatement of the Alternative Minimum Tax (AMT) and the expiration of the $10,000 limit on the federal deduction for state and local taxes (SALT) could further enhance the appeal of municipal bonds. "If we all of a sudden have 7.6 million taxpayers ensnared with AMT, we would anticipate that the spread you would need to be paid by buying the AMT paper would have to be wider," Close explains. The SALT deduction's expiration could also have a positive impact on the demographics and credit metrics of high-tax states, potentially benefiting municipal bond issuers in those regions.

Positioning Portfolios for Success

Given the favorable fundamentals and yields in the muni bond market, investment professionals are employing various strategies to capitalize on the opportunities. Vanguard's Paul Malloy favors investment-grade munis rated A and BBB with durations of 10 years or less, as they offer attractive yields without excessive interest rate risk.Nuveen's Close, on the other hand, is drawn to A, BBB, and below-investment-grade munis, citing the strong fundamentals and favorable technicals in these segments. He advocates a barbell strategy, focusing on the zero to two-year part of the curve and the 15-year part, as "you are getting paid to take duration risk."At AllianceBernstein, Norton's team is taking on more interest rate risk than usual, given the relative attractiveness of munis and the likelihood of further rate cuts. They are also positioning for lower-rated municipalities to outperform, as they expect high-yield muni funds to receive a disproportionate amount of inflows. Additionally, Norton favors a barbell approach, with one-year and 15- to 20-year bonds, to balance yield and risk.Across the board, investment professionals emphasize the importance of flexibility and active management in the current muni bond landscape. As the market dynamics continue to evolve, investors must remain nimble and ready to adapt their portfolios to capitalize on the changing opportunities.