Municipal bonds posted their best quarterly performance in nearly four decades, transforming 2023 into a year of solid gains after it looked like we were headed for a second consecutive annual loss. The remarkable turnaround was fueled by macro forces that unfolded over the final two months of the year. Recall that in October, interest rates were still in selloff mode, as a stubbornly strong economy and persistently high inflation gave teeth to the Federal Reserve’s “higher-for-longer” mantra. Later that month, the yield on the 10-year Treasury had risen to 5%, a 16-year high. From that point on, however, the data began to shift. Job growth softened meaningfully while price pressures eased, increasing the odds of a soft landing and fueling speculation of an impending monetary pivot. Fed officials virtually confirmed this view when they unexpectedly penciled in 75 basis points of cuts for 2024 in the December FOMC projection materials. The bond market, already rallying coming into the meeting, continued to surge into yearend. By the end of December, the 10-year yield had fallen to 3.88%, down almost 70 basis points for the quarter.
While the Treasury rally was the key factor driving performance in the fourth quarter, municipal bonds received additional boosts from limited issuance and sky-rocketing demand. Even during the October selloff, retail investors were jumping at the chance to lock in tax-equivalent yields not seen in over a decade, keeping municipals relatively well bid. When the market then started to turn, a healthy appetite for paper turned into a mad scramble, reflecting a fierce competition for bonds amid an end-of-year slowdown in issuance. The frenzy was amplified by a spike in rollover flows as well as an explosion of tax-loss harvesting, as participants hastened to reinvest proceeds before the market moved away from them.
Over the final two months of the year, the 10-year municipal yield fell 133 basis points. And when it was all said and done, you had to go back to 1986 to find a better quarterly return. 2023 now enters the history books as the sixth best annual return in the last two decades, an extraordinary outcome for a year that brought so much handwringing.
With the rapid ascent of yields through the middle of October, we decided it was time to ramp up our trading activity and extend duration. We fueled this move by purchasing bonds with maturities over 10 years and as far out as 25 years, taking advantage of the steepest part of the curve and tapping the additional supply available in that range. The trade produced immediate and impressive results as rates plummeted over the last two months of the year. The longer maturities we accumulated were our best performers. Meanwhile, the shorter, callable bonds were among the worst performers, despite carrying some of the highest yields heading into the trade. This should not have been surprising. The income component of total return is often swamped by price changes, especially over short time frames. The mistake of focusing solely on yield was magnified by the inverted shape of the curve, tempting many investors to stay short and clip coupons. The rally of the last two months showed how costly that seemingly conservative stance can be.
Looking ahead to January, the combination of seasonally-low supply, still-heavy reinvestment needs and an end to tax-loss selling should continue to foster the momentum built up over the past two months. Demand will be supported by a healthy fundamental backdrop and historically attractive tax-equivalent yields. The outlook for state and local governments remains solid, with most looking at low-single-digit revenue increases, manageable expense growth and significant financial flexibility, a product of record-high reserves. Investors will need to be alert to future volatility, especially with the market anticipating a sea change in monetary policy followed by a fast-approaching national election. One area to keep an eye on is how expensive valuations to Treasuries have become in the wake of the recent rally. While we don’t necessarily expect a quick unwind of these historically stretched ratios, municipal bonds are less likely to outperform Treasuries until we see those metrics improve. Even so, heading into a year with so much uncertainty, the high-quality stability offered by municipal bonds promises to draw even more interest to the asset class in 2024.
Read GW&K’s Quarterly Investment Review for the fourth quarter here.
With contributions from members of our Municipal Bond Team