Now that the Fed is signaling an end to rate hikes and the possibility of rate cuts, investors can focus on municipal bonds behaving like bonds: offering tax-exempt income and providing portfolio diversification. Indeed, reasons abound for considering a meaningful allocation to municipals.

Across the muni marketplace, credit fundamentals are in great shape, in the wake of Covid-19 related stimulus and three consecutive years of extremely strong revenues. We believe the market overall is well positioned to handle any economic downturn, should there be one. And the rating agencies agree, with upgrades outpacing downgrades by a roughly four-to-one ratio for three straight years.

Muni bond gross supply is expected to total $400 billion in 2024, up from $330 billion in 2023. However, with approximately $400 billion of bonds maturing or being called in 2024, supply will likely be net negative, with the expectation of demand exceeding supply. This supply/demand disparity should keep yields and spreads contained.

Getting Paid To Wait for Rate Cuts
We started 2024 at the highest muni yield levels since 2011. Even as the market has moved expectations of rate cuts further into the future, muni investors can enjoy attractive annual returns on income alone, a dynamic absent for nearly a decade. Essentially, investors are getting paid to wait for the Fed to begin cutting. And if the Fed does serve up cuts in 2024, look for cash to earn less and assets with longer durations to be in a position to outperform, perhaps pushing investors into munis and sparking a modest rally.

Today, we are seeing high-quality municipals offer tax-equivalent yields of 5.75% for investors in the highest tax bracket with even higher yield for high tax states. High yield municipals are offering tax-equivalent yields of 9.5%.

The tax-equivalent yields of high-grade munis are higher than corporate bonds, mortgage-backed securities and the Bloomberg Aggregate Bond Index, while offering lower historical defaults.

The 4th quarter of 2023 saw returns of 7.9% for the Bloomberg Municipal Bond Index, illustrating the return potential if the Fed begins to cut rates and yield levels begin to decline. As evidenced by the robust inflows for muni mutual funds that began the year, high-net-worth individuals are recognizing this return potential and the opportunity to lock in high tax-exempt yields before they potentially decline.

We believe that modestly extending duration can better position investors for this opportunity. Currently, the muni yield curve is inverted to about eight years, then becomes positively sloped out to 30 years. For investors with longer time horizons, we see considerable value in the intermediate to long ends of the curve—beginning with 15 years and longer.

Some Appealing Sectors
Depending on the investor's risk tolerance, here are some appealing allocation possibilities that have been uncovered by our credit research team's process:

High Grade Sectors:
• Water/sewer bonds: These are essential service monopolies that, even in a recession, generally see an inelastic demand curve. They currently have strong liquidity and cash on hand from federal Covid-19 relief programs.

• State and local government bonds:  Forty-one states have rainy day funds and record cash from Covid-19 relief. At the local level, most rely on stable property taxes and have broad authority to cut expenses and raise revenues.

High Yield Sectors:
• Land secured bonds: These are essential in nature, but lower in quality. We are looking at growth areas where issuers plan to develop land into new communities. Eventually, the community has a broader tax base as it grows, and the bonds are secured by a portion of property taxes.

Looking Ahead: Election Impact?
Given a favorable landscape, we believe the coming presidential election in the U.S.—whatever the outcome—will not have much bearing on municipal credit, although our team of analysts will be closely watching the state-level initiatives presented to voters.

Municipals enjoy broad support in Washington, D.C. The Fed provided backstop financing options for issuers during Covid-19 and issuers have benefited from five rounds of related financing, putting state and local governments in extremely strong financial position.

On the technical side, the last two cycles have shown a tendency for issuers to pull forward supply scheduled in November, December and even January ahead of U.S. elections. If that trend holds in 2024, we anticipate the potential for robust new issue supply in August, September and October.

An Improving Market In 2024
We believe the municipal bond market is poised for improvement in 2024. The Fed’s anticipated easing this year should bolster demand for muni bonds. If, as we expect, investor sentiment shifts positively, strengthening demand could absorb secondary market supply and act as a catalyst for spread tightening.

With attractive yields starting the year and solid credit fundamentals for state and local governments, we think muni bonds have compelling potential in diversified, long-term portfolios.

Daniel J. Close is the head of municipals at Nuveen and leads the municipal fixed income strategic direction and investment perspectives. Close serves as lead portfolio manager for high-yield municipal strategies, along with tax-exempt and taxable municipal strategies that include customized institutional portfolios, open-end funds and closed-end funds.