In this article, we review:
- The economic landscape as the Fed continues its easing cycle
- The resilience of municipal bonds amid continued volatility
- Record issuance and strong demand in the muni market
Shift to easing
The Federal Reserve's December 2024 meeting marked another significant step in its effort to manage inflation and stabilize the broader economy. The Fed reduced interest rates by 25 basis points to a range of 4.25% to 4.50%, following similar cuts in September and November. These actions reflect the Fed's ongoing transition from a tightening cycle to a more dovish approach, aimed at easing inflationary pressures in an environment of persistent economic uncertainties. The Fed’s most recent dot plot indicates a more measured approach moving forward, with only two additional rate cuts expected in 2025. This cautious stance underscores the tough balancing act the Fed is tasked with in order to maintain economic stability.
Amid these developments, key economic indicators suggest that we’re in a time of transition. The U.S. budget deficit hit $1.83 trillion in fiscal 2024, largely due to soaring interest costs and increased federal spending. Additionally, U.S. household debt reached an all-time high of $17.9 trillion, exacerbating financial strain for lower-income groups and younger consumers. Rising debt levels and growing delinquencies could lead to reduced consumer spending and tighter lending, further slowing economic growth. On the corporate side, bankruptcies surged in November, driven by pressures from high interest rates, inflation, and shifting consumer behavior, particularly in sectors like consumer discretionary, staples, and industrials. The labor market also remains weak, with job postings experiencing a significant decline, pointing to the broader challenges facing the economy.
As of February 25, 2025. Source: Bloomberg
The current muni opportunity
With the Fed transitioning to an easing cycle and anticipated cuts to federal government spending, many state and local governments are poised to issue more debt to fund critical infrastructure projects and get ahead of future capital needs. Many municipalities strengthened their financial positions significantly in recent years, thanks in part to federal COVID relief funds, which bolstered their balance sheets and provided additional liquidity during challenging economic conditions. This fiscal support has been a crucial factor in enhancing the creditworthiness of many local governments, making municipal bonds an appealing option for risk-averse investors.
With their attractive risk-return profile and current elevated yields, municipal bonds may offer investors a reliable shelter from broader market fluctuations and an important tool for portfolio diversification. U.S. Corporate Bond credit spreads have compressed to near-record-tight levels and equity valuations remain high, so as a low-correlation asset class, munis may remain resilient should potential economic woes begin to materialize.
As of December 31, 2024. Source: Moody's Ratings
Supply and demand
2024 featured record-breaking tax-exempt supply, with over $500 billion in total issuance — over a 30% year-over-year increase. Similar or higher issuance levels are anticipated in 2025, driven by inflationary project costs, M&A activity, and reduced federal aid. The ongoing borrowing is a response to governments' critical infrastructure needs and the need to address inflationary pressures, while also adjusting to reduced federal support. The historical supply in 2024 was overall well received by investor demand, highlighting the strength of the muni bond market, even among continued volatility and uncertainty.
Additionally, after significant outflows from the market in 2022 as interest rates rose precipitously, portfolios continued to be underweight municipal exposure, exasperated by a prolonged yield curve inversion. Now that the municipal yield curve has dis-inverted, there may be an increase in appetite for more exposure along the curve into longer maturities, particularly from those investors who reduced their exposure a few years ago and have not yet returned. The outsized supply in 2024 helped buoy municipal yields at historically high levels, which bodes well for investors looking to re-enter the market as we head into another potential record year for supply.
As of December 31, 2024. Source: SIFMA
With the Fed’s easing cycle creating more favorable conditions for municipal bond markets, coupled with supportive supply and demand dynamics and solid credit fundamentals, now is an opportune time for investors to consider munis as part of a diversified portfolio that can provide tax-advantaged income and resiliency during these uncertain times.
About the author
Cara Grealy is a portfolio manager on the Investment Team at Belle Haven Investments. Cara launched her career in the industry upon joining Belle Haven in 2011 as an associate. She has been a member of the Investment Team since that time and was named a partner of the firm in 2017. She worked her way through various roles over the years, using the accumulated knowledge as a stepping-stone to her present position as a portfolio manager. Her current responsibilities focus on risk and portfolio construction and overseeing the reporting and analytics team. Throughout her tenure, Cara has leveraged her deep knowledge of the firm’s internal systems and macro view of the firm’s investment process to provide the team with a unique leadership perspective.
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The interest from municipal bonds is expected to be exempt from federal income tax. If a fund investor is a resident in the state of issuance of the bonds held by the fund, interest dividends may also be free of state and local income taxes. Such interest dividends may be subject to federal and/or state alternative minimum taxes. Municipal bond prices can rise or fall depending on interest rates. Interest rates may go up, causing the value of the Fund's investments to decline. The municipal bond market can be susceptible to unusual volatility, particularly for lower-rated and unrated securities. All municipal bonds carry credit risk that the issuer will default or be unable to make timely payments of interest and principal. Generally, lower rated bonds carry more credit risk. High-yield bond (junk bonds) funds may be subject to greater volatility and risks as the income derived from these securities is not guaranteed and may be unpredictable and the value of these securities tends to decline when interest rates increase.
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