Economic growth is slowing, inflation is normalizing, and the U.S. Federal Reserve is expected to begin cutting interest rates later this year, all of which should encourage municipal bond investors to take advantage of this elevated yield environment to lock in longer-term yields.

Looking back at 2023, those who maintained a neutral positioning were largely rewarded with lower volatility and positive returns. Looking ahead, with interest rates forecasted to fall, investors may be able to achieve near equity-like returns in municipals, owing to elevated coupon income and price appreciation.

Supply should increase but in a constrained fashion, so valuations are unlikely to deteriorate. With the strong credit backdrop, appropriately sized allocations to lower-rated municipal credits may enhance returns.

Why Munis?
With long-term negative correlations to most other major asset classes, muni bonds continue to offer diversification benefits and a portfolio ballast when volatility rises. Many individual investors view these as core holdings and are usually unconcerned with day-to-day market swings.

Investors whose portfolios include equities (private and public), commodities, or real estate may benefit from allocations to municipal bond separately managed accounts (SMAs). Advisors can customize them to manage risk tolerances and tax consequences, targeting after-tax yields that suit each client’s unique profile. Furthermore, investors often appreciate the transparency and tax-efficient liquidity of these SMA products.

Rise Of SMAs
The municipal bond market does not trade on an exchange and is fragmented across hundreds of counterparties, often making it difficult for financial advisors to source bonds on their own. They cannot fill clients’ orders by simply hitting a button, nor do they want to spend time to find and buy bonds when they prefer to be out in the field, servicing clients and seeking new ones.

SMAs are proving especially popular with high-net-worth investors who want core conservative bond holdings that are customizable, transparent and adaptable as needs change. As a result, assets in muni bond SMAs have grown roughly tenfold in the last 15 years, outstripping mutual funds to become the main driver of municipal inflows during the past year.

SMA Appeal Has Broadened As Complexity Has Risen
The first big move came in 2008. Municipals were largely a rate market; virtually all bonds were rated AAA and insured by monoline insurers, so credit research was often unnecessary. Then the Global Financial Crisis hit, and munis suddenly became a credit market; managers and investors needed to do due diligence, which many advisors were not prepared, nor readily able, to do.

The second came from the Tax Cuts and Jobs Act of 2017, changing supply dynamics in terms of tax exemption eligibility: specifically, the issuance of tax exempt versus taxable municipal bonds. Advisors who were still doing it in a brokerage capacity now had to calculate valuations of tax-exempt munis versus taxable munis versus U.S. Treasuries, adding complication.

The third move has come with the huge run-up in yields over the past couple of years. Investors who were not invested in fixed income, or underweight their desired allocations, suddenly wanted to buy bonds. This has turbocharged demand, especially over the last six months.

Trends Muni Investors May Be Able To Take Advantage Of In 2024
Lower Absolute Yields—With inflation closer to normalized levels, the Fed is likely done raising rates and may be positioning to lower them. Projected slower economic growth and a weaker labor market could lead to lower yields and the potential for equity-like returns in bonds.

Continued Strength In High Grade Municipal Credit—Boosted by healthy reserve balances, investment grade (IG) municipal issuers remain on solid footing. This strong starting point should provide a needed cushion given anticipated declines in revenues and federal aid.

Lower-Rated Credit Opportunities—Credit spreads remain attractive, creating opportunities across many sectors, but careful credit selection will continue to be a key focus.

Investors may want to consider looking across various fixed income asset classes to optimize for enhanced after-tax income. Diversification within the IG space has been vital as different segments of the market deliver varying degrees of risk, return, and income over time.

A note of caution: for those who have historically invested solely in tax-exempt municipal bonds, buying taxable municipals and corporate bonds for their portfolios may introduce more volatility. The potential income can improve portfolio returns but not without additional risk.

Ed Paulinski is head of municipal separately managed accounts at Goldman Sachs Asset Management.