The S&P Municipal Bond Index gained 2.7% for the quarter, while the S&P Municipal Bond High Yield Index widened its year-to-date outperformance over its investment grade analog by tacking on an additional 80 basis points to 3.5%. The S&P Short Duration Municipal Yield Index advanced 2.7%. All three lagged the 5.2% gain of the Bloomberg US Aggregate Index during the quarter.¹ 

Muni Yields Pull Back on Rate Cut but Remain Attractive
 The Federal Reserve kicked off its much anticipated rate-cut cycle in mid-September, announcing an oversized 50 basis point cut that was at the larger end of market expectations and brought the central bank’s key policy rate to a range of 4.75–5.00%. Perhaps wanting to get ahead of any negative interpretations that could be attached to the larger-than-typical cut, Fed Chair Powell characterized the move as a “recalibration” of policy that reflected the committee’s growing confidence that labor-market strength could be preserved amid healthy economic growth and further cooling in inflation.²

Assuming risks to the labor market and inflation remain balanced, the Fed is seeking to move gradually toward the neutral rate of interest—the hypothetical fed funds level that neither stimulates the economy nor restrains it, which the central bank currently estimates to be about 2.9%. The latest dot plot of fed funds rate projections suggests an additional 50 basis points of cuts in 2024 and 100 basis points in 2025, which would put the Fed on track to reach a neutral policy setting in early 2026.3 Futures markets had anticipated a more aggressive pace of cuts in the immediate aftermath of the Fed meeting, but have since tempered their expectations following the early-October release of an unexpectedly strong jobs report.⁴

Anticipation of the Fed’s move sent yields lower across the fixed income complex throughout the third quarter and had a steepening impact on yield curves. The 10-year Treasury rate ended the period about 55 basis points lower, while the response in municipal markets was more restrained, with yields in the high grade and high yield muni indexes compressing by 28 basis points and 22 basis points, respectively⁵. We saw spread narrowing at the muni index level, particularly in the high yield space, but—as always given the diverse nature of the muni market—dispersion across issues was significant.

Muni Issuance and Demand Continue to Rebound Amid Supportive Macro Backdrop

Despite what the Fed’s large rate cut may suggest, the US economy has continued to hum along. To wit, the Atlanta Fed’s GDPNow model estimates third quarter economic growth of 3.2%, up from the second quarter’s 3.0% expansion.⁶ The unemployment rate has bounced off its April 2023 record low but at 4.2% is well below the historical average and likely pretty close to the theoretical nonaccelerating inflationary rate of unemployment (NAIRU).⁷ The latest core personal consumption expenditures price index print came in at 2.7% and probably would be even closer to the Fed’s 2% target were it not for undersupplied housing markets.⁸

Muni issuer fundamentals have benefited from this environment. Tax revenue at the state and local levels remains high and continues to grow, which in conjunction with generally strong fiscal profiles has helped keep defaults very low, even by the standards of an asset class accustomed to very low default activity. Year to date through September, there has been about $1.3 billion of par value affected by a first-time payment default.⁹ The upgrade/downgrade ratio has pulled back from very high levels but remains favorable.¹⁰ We think current fiscal dynamics should support historically low default rates as well as high recovery rates.

A supply/demand imbalance helped buoy muni bond prices in recent years as interest rates crept higher, and market technicals have continued to be supportive of the asset class as rates stabilized at attractive levels in 2024. Throughout the year, we have seen increased new-issue supply being met by ample demand fueled by absolute and tax-equivalent yields that remain high relative to post global financial crisis history.

Supply has continued to benefit from relative stability in interest rates following a period of volatility. At more than $400 billion, year-to-date issuance already exceeds full-year metrics for 2022 and 2023.11 Stable-to-lower interest rates are likely to be an ongoing tailwind for issuance, though it would not be surprising to see the pace ease somewhat in the fourth quarter. October has gotten off to a strong start, but activity typically slows around the Thanksgiving and December holidays; further, the uncertainty around this year’s presidential election likely prompted some issuers to move their planned bond offerings ahead of November 5.

In terms of demand, muni bond mutual funds and exchange-traded funds have attracted more than $28 billion in assets year to date through September, 47% of which have gone into high yield strategies. Given that muni bond strategies saw an exodus of $132 billion in 2022 and 2023 combined after peaking at nearly $1 trillion in fourth quarter 2021, it’s possible we are in only the early innings of a normalization in investor demand.12

The Appeal of Munis Persists, in Our View

We expect muni bond prices to continue to be supported by both market technicals and issuer fundamentals in the short term. While yields have pulled back in conjunction with the Fed’s pivot to easier monetary policy, they remain elevated relative to levels that have prevailed for most of the post-global financial crisis period and continue to offer investors an opportunity, in our view.

While we are constructive on municipal bonds as an asset class, we believe skilled active managers can add additional value in what is a very large and highly fragmented market. Through rigorous underwriting we seek to uncover hidden gems that we believe are well managed and well positioned in their markets while offering the potential for favorable yields and dollar prices that could compensate for the risks. Our bottom-up approach also seeks to avoid potential landmines; notably, First Eagle’s municipal bond portfolios did not have any exposure to the defaulted securities mentioned earlier.

Our investment professionals have extensive experience in the municipal bond market, but First Eagle’s muni strategies themselves are less than a year old. The timing of our launch and the initial small size of the portfolio resulted in an unsustainably high distribution yield earlier in the year. The appreciation of the fund’s net asset value combined with the investment of new capital in a slightly lower-rate environment has exerted some moderate downward pressure on the distribution yield, which we believe has largely stabilized at this point.