Signals point to a better bid muni market to close out 2024

Municipals were steady to slightly weaker Tuesday as U.S. Treasuries closed the session a bit stronger while equities were in the black.

Triple-A yields rose by a basis point or two while USTs were better by one to two basis points.

The two-year municipal to UST ratio Tuesday was at 65%, the five-year at 65%, the 10-year at 67% and the 30-year at 82%, according to Municipal Market Data's 1 p.m. EST read. ICE Data Services had the two-year at 65%, the five-year at 65%, the 10-year at 67% and the 30-year at 81% at 1 p.m.

In the remaining days of this year, "taxable rates continue to be pressured but munis are finding a stable, even supportive, bidside," said Kim Olsan, a senior fixed income portfolio manager at NewSquare Capital.

The 10-year UST opened Tuesday at 4.60%, 10 basis points off late April's high of 4.70%, she said.

"Corresponding tax-exempt yields are effectively at 3.00% or higher (excluding high grades in the 2027-2030 range) and are poised to close out the year at their highest levels of 2024," she said.

Several late-year developments stand out, Olsan said.

For one, tax-exempt money markets are "ceding assets," she said, with the Investment Company Institute reporting $132 billion held in the sector.

This is down from this year's high of $137 billion at the start of December, Olsan said.

Weekly floater rates have risen to near 3.75% or 75 basis points higher than levels seen two weeks ago, she said.

"That shift suggests cash is being deployed out the curve in response to the upward yield move," Olsan said.

The last five sessions have seen a "combined 67% of all secondary trades (tax-exempt, non-AMT) in maturities past 2030, with a large (30%+) representation of inter-dealer trades," she said.

Additionally, she said the curve slope is "encouraging extension."

Following flat and negatively sloped curves for most of 2024, the intermediate range (10-20 years) has steepened to near period highs, according to Olsan.

"The 10s5s and 15s10s MMD AAA slopes each stand at 21 basis points and the 20s10s curve is a generous 56 basis points," she said.

While the 2020 period held a "similar extension value," historically low rates defined that period. For example, Washington sold GOs in July 2020 with 5s due in 20 years yielding 1.46%, while Washington GO 5% due 2046 (call 2033) traded at 3.95% this week, she said.

And, "despite longer-run pressure on ratios, current absolute yields are trading at annual highs," Olsan said. "Following a 25 basis point correction since the start of the month, the AAA BVAL yield stands at 3.11% and effectively near the early November high of 3.12%."

The average yield over the year is 2.64%.

"The corresponding 10-year BVAL/UST ratio is currently 68%, or 4 percentage points above the year's daily average," Olsan said. "Over a wider range since the tightening cycle began in March 2022, the median ratio is 71%."

2025 outlook
In 2025, "Treasury rates, the economy, and market technicals will all play a role, as they usually do, in determining the outcomes in the muni market," UBS strategists said.

While election years usually see a greater degree of uncertainty surrounding the impact of fiscal and tax policy on the muni market, this time it is "particularly pronounced," they said.

It's possible that some types of municipal bonds may lose their tax-exempt status, but UBS strategists do not expect the impact to be widespread.

Even if they are wrong, UBS strategists noted, "existing bonds will likely be grandfathered, potentially increasing their scarcity value."

The potential resurgence of inflation driven by tariffs and deficits is another risk factor, they said.

"While there is little doubt that the fiscal deficit will be elevated in 2025 and new tariffs will be implemented, we believe actual outcomes will be influenced and moderated by fiscal hawks in the Republican party and those who remain somewhat wary of aggressive protectionist measures," they said.

On the supply side, UBS strategists expect tax-exempt supply to be more than $450 billion next year, driven by continued pent-up needs for infrastructure investment.

"Concerns around the tax exemption could pull forward the issuance of private activity bonds in the not-for-profit college and hospital sectors," they said.

Turning to credit, "waning fiscal aid will be a headwind for some muni issuers in 2025," said Cooper Howard, a fixed income strategist at Charles Schwab (SCHW).

"Although many issuers' liquidity positions are high, fiscal aid is waning and what happens next poses a headwind to some municipalities," he said. "The money provided under the American Rescue Plan Act must be designated what it will be used for by the end of this year and spent by the end of 2026."

A credit risk for next year and beyond is some issuers "chose to allocate those funds to recurring, rather than one time, expenses and once the funds run out, they'll have to find additional sources of revenue or cut back on expenses," Howard said.

While munis have sold off as of late, UBS strategists expect AAA muni yields to decline moderately.

Muni-UST ratios are on the richer side versus five- and 10-year historical averages but will likely remain range-bound in 2025, they said.

"Given our expectations for a strong economy, we don't expect credit spreads to change significantly," they said. "BBB and HY spreads will remain tight relative to historical averages."

AAA scales
MMD's scale was little changed: The one-year was at 2.86% (unch) and 2.82% (+2) in two years. The five-year was at 2.87% (unch), the 10-year at 3.08% (unch) and the 30-year at 3.92% (unch) at 1 p.m.

The ICE AAA yield curve was unchanged: 2.90% in 2025 and 2.83% in 2026. The five-year was at 2.88%, the 10-year was at 3.08% and the 30-year was at 3.87% at 1 p.m.

Bloomberg BVAL was cut one to two basis points: 2.96% (+1) in 2025 and 2.82% (+1) in 2026. The five-year at 2.90% (+2), the 10-year at 3.14% (+2) and the 30-year at 3.85% (+2) at 1 p.m.

Treasuries were little changed to stronger.

The two-year UST was yielding 4.337% (-1), the three-year was at 4.365% (flat), the five-year at 4.437% (flat), the 10-year at 4.589% (-1), the 20-year at 4.847% (-2) and the 30-year at 4.762% (-2) at 2 p.m.