These bonds offering tax-free income will still be a good deal in 2024

Published Wed, Dec 27 202310:35 AM ESTUpdated Wed, Dec 27 20232:54 PM EST

Municipal bonds, favored for their tax-free income, are looking at a solid year in 2024 and could be a compelling purchase for investors hoping to lock in attractive yields. Munis, along with an array of fixed-income assets, saw a sizable bump in yields amid the Federal Reserve's rate-hiking campaign. However, rates have calmed as the year winds down – the 10-year Treasury yield is around 3.8%, far off its October highs of more than 5%. "We will likely see positive total returns," said Cooper Howard, fixed income strategist at the Schwab Center for Financial Research. "Outperformance relative to Treasurys might be difficult, but the positive view boils down to two points: High absolute yields and good credit." The Morningstar U.S. Municipal Bond index has a roughly 6.4% total return in 2023, up sharply from its -9.2% return in the prior year as a sharp rise in rates led to falling prices for fixed income. Bond yields and prices have an inverse relationship to one another. With the central bank penciling in three rate cuts in 2024 , investors who've snapped up longer-dated munis could see another silver lining in addition to locking in today's higher yields: rising prices on the holdings. "If the trend line for government bond yields is lower, there's a high probability the muni bonds will follow suit – you get capital appreciation from duration in the muni market," said Peter Higgins, head of fixed income and senior portfolio manager at Shelton Capital Management. Tax-free municipals are generally lower risk – and lower yielding – compared to their corporate counterparts. However, the fact that they generate income free of federal taxes (and free of state taxes if investors reside in the same state as the issuer) means a high-income investor would have to find a higher-yielding corporate bond in order to match what he or she would get from a muni bond. To that effect, if a muni bond yields 3.5%, an investor in the 32% tax bracket would have to find a taxable bond yielding 5.15% to generate comparable income, according to New York Life Investments . More flows, higher duration The forecast for rate cuts in the new year isn't great news for investors hiding out in money market funds : Yields on cash are going to come down. However, by adding more duration – that is, raising exposure to longer-dated bonds with more price sensitivity – investors get to benefit from locking in higher yields and the opportunity for price appreciation. "The longer-duration nature of the asset class can potentially reduce the reinvestment risk present with the recently popular money market instruments," said Ben Barber, director of municipal bonds at Franklin Templeton Fixed Income, in his muni outlook. "A sustained increase in demand should support muni bond performance over the coming months." Schwab's Howard pointed out that longer-term municipal bonds offer investors more relative value compared to the short-term counterparts. "The gap between AAA-rated municipal bonds and Treasury bonds after taxes is fairly tight up until about 10 years, and then begins to widen out," he pointed out in his muni outlook. Given the current set-up, Paul Malloy, head of municipal investment at Vanguard, likes the idea of using a barbell to get intermediate-level duration. That involves using a short-term fund, like the asset manager's Short-Term Tax-Exempt Bond ETF (VTES) and a longer-dated fund, such as the Vanguard Long-Term Tax-Exempt Fund (VWLTX) . "Munis are one of the best things going in the fixed income space," he said. "It's got yield. It provides all the attributes of fixed income, and it serves as ballast to an overall diversified portfolio." Issues to watch in 2024 There are a couple of developments on the horizon in 2024 in the muni world. "There are higher balances in municipalities' rainy day funds, and the economy remains relatively strong, and tax collections are supportive of municipal budgets," said Beth Foos, associate director, fixed income strategies, at Morningstar. "That said, there is still a possibility for revenue slowing," she added, and that is all the more reason for managers to focus on credit quality and projects that are going to remain resilient even in a slowing economy. Naturally, rates are on the minds of fixed income investors and strategists, as well as recession risk. "The Fed is still trying to navigate the economy from this restrictive policy stance, and that means that there are recession risks still on the table for 2024 – and it means the high yield part of the muni market is an area where we have to be ultra selective," said Malloy. Finally, elections in the new year are worth eyeing. That's because a slate of provisions in the Tax Cuts and Jobs Act are due to sunset at the end of 2025. The TCJA currently places a $10,000 cap on the state and local tax deduction – a write-off that was popular with taxpayers who itemize deductions and reside in states with high income and property taxes , such as New York, New Jersey and California – and this so-called SALT deduction is set to expire at the end of 2025. What will happen with the TCJA and the SALT deduction will depend on the outcome of state and presidential elections in 2024 – and that could make waves for munis. "It takes a long way to get to tax law changes, but if there is talk of it on the campaign trail, that can create headline risk," said Howard. Even with these issues, investors with a long-term perspective may benefit from adding to their high quality muni bond exposure while it's still cheap. "If you're in a higher tax bracket, it's a great time to re-establish your fixed income positions, especially if you've been holding cash," Malloy said.