The Case for Long-Term Munis: Positioning for Rate Cuts

The Case for Long-Term Munis: Positioning for Rate Cuts

The Federal Funds rate has held steady at 5.33% for over a year, but the Federal Reserve (Fed) is now signaling that this period may be coming to an end. With potential rate cuts on the horizon in September, long-term municipal bonds are becoming more attractive. This blog will explore why now could be the ideal time to consider reallocating into long-term munis.

• Fed Rate Cycles and Long-Term Munis
• The Case for Long-Term Munis
• Superior Credit Quality
• Strong Historical Performance
• Competitive Yields and Tax Benefits
• Strong Municipal Bond Issuance
• Conclusion

Understanding the Fed Rate Cycles and Long-Term Munis

Historically, long-term bonds, including munis, tend to benefit when the Fed shifts from hawkish to dovish, and historical data shows strong returns after these shifts. This potential makes long-term munis attractive as these longer bonds offer higher income and potential total returns.

The Case for Long-Term Munis

Long-term municipal bonds are emerging as a strong alternative to Treasuries. Municipal bonds are exempt from federal taxes and, in some cases, exempt from state and local taxes. They typically offer solid credit quality and can provide a higher tax-equivalent yield compared to taxable bonds. The longer the duration, the larger the potential for price appreciation during periods of interest rate cuts. For example, the ICE Long AMT-Free Broad National Municipal Index (MBNL), which tracks 'long munis,' has a modified duration to worst of 13 years. This means that if interest rates dropped by 1%, the index’s price could potentially rise by approximately 13%. The current modified duration to worst of long munis is still near the longest it’s been in the last ten years, meaning these bonds are more sensitive to interest rate changes than usual.

Current Era of Duration is the Longest in a Decade

Source: ICE. As of 8/31/2024. Past performance is no guarantee of future results. Modified Duration measures a bond’s sensitivity to interest rate changes that reflect the change in a bond’s price given a change in yield. Please see index definitions disclosures at the bottom of the page. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.

Superior Credit Quality

Long-term munis credit quality is better compared to a decade ago. Improved credit rating processes and the enhanced financial health of issuers have led to lower default rates for municipal bonds relative to corporate bonds. Ratings illustrate this strength in quality. According to ICE, the average credit rating for municipal bonds has steadily improved over the past decade, rising from 760 to 780. Meanwhile, the average credit rating for U.S. Treasuries dropped from 864 to 816 after Fitch downgraded them to AA+. Muni credit ratings have become a comparable alternative to those of U.S. Treasuries.

Munis and Treasuries Have Similar Credit Quality

Source: ICE. As of 8/31/2024. Past performance is no guarantee of future results. The ICE Average Credit Rating is a composite rating calculating using simple averages of ratings from Moody’s, S&P and Fitch. The composite rating is calculated by assigning a numeric equivalent to the ratings in each agency’s scale. See index definitions and disclosures at the bottom of the page. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.

Source: ICE. As of 8/31/2024. Past performance is no guarantee of future results. See index definitions disclosures at the bottom of the page. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.

Competitive Yields and Tax Advantages

Long-term munis offer competitive yields when compared to other fixed-income assets. Proposed changes in top marginal tax rates could increase demand for tax-exempt munis, especially with the potential sunsetting of the Tax Cuts and Jobs Act (TCJA) in 2025. This would bring back a top marginal rate of 39.6%. The election could have a significant impact on munis, depending on how the future administration handles the top marginal tax rate. Former President Trump has previously suggested extending the TCJA, while Vice President Harris will likely let the TJCA expire.

Long-Term Munis Top Other Bond Categories in Yield to Worst

Source: ICE. As of 8/26/2024. Yield to Worst (YTW) is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. See index definitions disclosures at the bottom of the page. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.

Strong Municipal Bond Issuance

Lastly, the supply of municipal bonds has gotten off to a big start this year. Even with the possibility of lower rates in the future, issuers have issued more new debt than ever in the last decade. Issuers may be getting ahead of the U.S. election. The increased issuance earlier this year presents a unique buying opportunity due to the higher supply, often leading to better prices for investors.

Muni Issuance this Year (Through January) is the Highest in a Decade

Source: Bloomberg . As of July 31, 2024.

Conclusion

We believe now is a compelling time to consider long-term munis. With the Federal Reserve signaling potential rate cuts and long-term munis offering competitive yields, the VanEck Long Muni ETF (MLN) stands out. These bonds benefit from higher yields, tax-exempt status, and potential capital appreciation, making them an attractive option in the current environment.

For investors seeking a robust, long-term horizon, the risk-reward profile of long-term munis in the current economic environment is compelling. Consider the VanEck Long Muni ETF (MLN) as a strategic move in your financial portfolio, taking full advantage of the evolving market dynamics.

Source: Moody’s Investors Service: US municipal bond defaults and recoveries, 1970-2022.