Municipal Bond News 12/18/23

Historic Muni Bond Rally…Wall Street-Federal Reserve Divided…Pace of 2024 Rate Cuts…California’s Spending Freeze…Pritzker Urges ‘Careful’ Approach…Higher Education Outlook Boosted…

Historic Muni Bond Rally…In a victory lap, municipal bonds have dethroned cash. An end to the Federal Reserve’s tightening cycle has brought gains to municipal bonds. A muni bond rally, which began in November, has delivered over 6.5% year-to-date gains for a broad muni bond index. The gains come after a broad muni bond index posted losses of over 8.5% in 2022 and a paltry 1.5% gain in 2021. Muni bond yields peaked in October, at levels not seen since 2009, and delivered equity-like tax-free income from state and local government bonds. Muni bond yields have dropped 115 basis points since November. Current muni bond yields are at levels seen at the start of 2023. This year, a top-rated long-term muni yield index has ranged from 3.2% to 4.65% reflecting volatile market conditions. Last week, muni bond yields fell close to 15 basis points, after bellwether U.S. Treasury bond yields declined 30 basis points, hitting the lowest since August. New muni bonds issued last week, such as an Illinois toll road bond, were repriced at lower yields. The rapid drop in yields has sparked a search for higher yield, causing longer-dated high yield muni bonds to outperform with 10% index returns this year. A Municipal Bond Specialist can offer the expertise to find and research story bonds, that are often lower- rated and higher-yielding.

Wall Street-Federal Reserve Divided…Fed officials have penciled in three rate cuts in 2024, while bond markets are pricing in as many as six quarter- point rate cuts starting in March. Bond expert Jeffrey Gundlach anticipates the Fed will slash policy rates by a full two percentage points next year. Capital Economics predicts seven quarter-point rate cuts. Morgan Stanley expects 300 basis points of rate cuts next year, which could take the policy rate down to 2.37% a year from now. Goldman Sachs economists predict 25 -basis point rate cuts in March, May, June, and further moves on a quarterly basis, betting that inflation will slow to the Fed’s 2% target by the end of next year. Wall Street expects as many as seven 25-basis point rate cuts next year. Inflation has declined faster-than-expected, spurring 80% odds of rate cuts as early as March.

Pace of 2024 Rate Cuts…Rate hikes are in the past, no Fed official sees higher rates next year. Eleven of 19 Fed officials anticipate at least three quarter-point rate cuts next year, and an additional five suggest two rate cuts. In September, Fed officials projected one more rate hike this year. Instead, the Fed extended a pause on rate hikes that began in July. Fed Chair Powell explained, “Our actions have moved our policy rate well into restrictive territory, meaning that tight policy is putting downward pressure on economic activity and inflation, and the full effects of our tightening likely have not yet been felt.” Chicago Fed President Austan Goolsbee said policymakers might need to prepare to lower rates sooner than they had previously anticipated. “Pretty soon here we’re going to get back to the employment side of the mandate being just as relevant,” Goolsbee added that because interest rates are at levels that should restrict economic activity, officials need to remember that when unemployment rises, it tends to go up by a lot. Meanwhile, New York Fed President said “It’s just premature to be even thinking” about a March rate cut. Another official, Atlanta Fed President Raphael Bostic said he didn’t think the central bank would need to lower interest rates until the second half of next year, and he suggests two rate cuts in 2024.

California’s Spending Freeze…To address California’s budget deficit, Governor Newsom ordered a spending freeze for state agencies, cutting general fund expenses in the current year. California’s approved budget for the 2023-2024 fiscal year was $310.8 billion. The state last adopted a spending freeze at the beginning of the COVID-19 pandemic in early 2020 when state revenues rapidly declined. While the estimated revenue decline is significant, California’s general fund revenues increased by $78 billion or 54% between fiscal 2020 and fiscal 2022, without a concurrent increase in ongoing spending. A combination of revenue surpluses and structural budget improvements have led to record reserves. California retains ample tools to address an emerging revenue shortfall.

Pritzker Urges ‘Careful’ Approach…Illinois could end up with a surplus of $1.4 billion in the current fiscal year, while Fiscal 25 could bring a $891 million deficit. The latest five-year forecast of Illinois general fund revenue projects deficits of over $1 billion from Fy2026 to Fy2029. Future year budgets can be “very hard to project” due to state, national and global economic factors, Governor Pritzker added, “I think you’re going to see different projections as we go forward just because the economy is changing.” Recent revenue outperformance boosted funding to reserves and pensions. “So that five-year forecast, you know, we look at it as a guide for how careful do we need to be as we move forward in the in the budget year thinking about FY ’25,” Gov. Pritzker added “I think it’s a signal that everybody, we need to be careful in Illinois, we have to balance our budget…”

Higher Education Outlook Boosted…Colleges and universities will see revenue gains materialize. In 2024, net tuition revenue could grow between 3.5% and 2.7% per a Moody’s tuition survey. State appropriations, sector-wide, are likely to increase by more than 5% for the third consecutive year in Fiscal 24. State funding outlook for 2025 is less certain as states prepare for slowing tax collections. As the residual effects of the pandemic wane, an improving healthcare landscape is favorable for academic medical centers. Federal cash infusion of $76 billion between 2020 and 2022 propped up college revenues between 2020 and 2022. As the last of federal aid was spent, the higher ed sector saw paltry revenue growth in 2023. However, endowments and donor support boosted college balance sheets and operations.

Compare 30-Year taxable U.S. Treasury yield 4.02% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.50%; “AA” 3.83%%; “A”4.19%. For investors in the 35% tax bracket, a 3.5% tax-exempt yield is equivalent to a 5.4% taxable yield. Top-rated long-term tax-free bonds yield 87% of comparable taxable U.S. Treasuries.