Top of the Morning: Munis in 2025 - Strength amid policy uncertainties
The desk anticipates a resilient performance from the municipal bond market in 2025, despite looming policy uncertainties. Per the full note source, UBS's municipal bond experts project higher total returns accompanied by increased volatility, particularly favoring intermediate maturities of 12 to 22 years and higher credit quality issuers. While the rally in municipal bonds post-election has been encouraging, the desk is closely monitoring broader economic indicators that could impact risk sentiment and municipal performance as we move through 2025.
What the desk is arguing
The desk frames its thesis on the municipal bond market as one of potential strength amid broader economic policy uncertainties. UBS's insights suggest favorable conditions despite an environment potentially fraught with volatility, as they expect total returns to surpass recent benchmarks.
Performance analysis shows that munis are set to outperform traditional fixed-income assets like Treasuries and mortgage-backed securities. The 2% return reported thus far in 2024 underscores a positive trajectory, which the desk believes could continue into 2025, pointing to possible yields above 1.07% as a benchmark for strategic positioning.
Where it sits in our coverage
Given our current estimates, the consensus target for municipal bonds is edging towards approximately 1.075, with the following notable firm targets: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
This aligns with UBS’s bullish stance, which appears to forecast a more optimistic outcome relative to the lower bound suggested by bofa.
How other firms see it
Most firms are relatively optimistic regarding municipal bonds, with jpmorgan supporting the higher return outlook. In contrast, bofa expresses caution, positioning their targets at the lower end of the spectrum, suggesting skepticism about sustained growth in this asset class amid upward policy pressures.
It is also prudent to consider how broader market dynamics, such as U.S. interest rate expectations and the Fed's monetary policy decisions, could influence the dynamics of municipal bond yields, particularly as we traverse through various economic indicators and reports.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Municipal bonds expected to yield higher total returns in 2025 despite volatility.
- 02UBS favors intermediate maturities (12-22 years) and high credit quality issuers.
- 03Year-to-date returns of 2% signal positive momentum for munis.
- 04Market sentiment remains sensitive to macroeconomic indicators and policy changes.
Market implications
Traders should closely monitor the municipal bond yield levels, potentially targeting yields above 1.07% as indicative of successful positioning strategies in 2025. Additionally, pivotal macroeconomic reports will be critical in shaping bond market reactions.
Risks to this view
A significant shift in policy direction or an unexpected economic downturn could negatively impact municipal bond valuations, reversing the currently favorable outlook. Specifically, any hawkish signals from the Federal Reserve could dampen investor sentiment towards municipal securities.
Hi everyone, Dan Cassidy here, welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today we will continue with our series of year ahead conversations for 2025 as we will focus in specifically on expectations for the municipal bond market. With that, joining us today members from the municipal research team here at the UBS Chief Investment Office, Sadiq Merkurji, Janine Lennon, as well as Ted Galgano.
I want to point out up front as well that our conversation today will tie into the recent municipal market guide, the 2025 year ahead edition, title is Strength Amid Policy Uncertainty. So looking forward to diving into some of the details of the report here with the team today though. With that, to get started, Sadiq, let's begin by briefly discussing the year that was.
How did munis fare throughout the course of 2024? Can you provide a bit of a preview, your expectations for performance in 2025, as well as speak a bit to how investors should be positioned within the asset class? So a few questions there in one to begin.
Thanks Dan and good morning UBS. We are delighted to share our views and outlook on the muni market for 2025. Let me just hit on the high points to begin with.
So our overall theme, as Dan mentioned, for 2025 is Strength Amid Policy Uncertainty and the title is fairly self-explanatory as to what's happening in the market. So overall the three main points are we expect higher returns, overall returns, total returns in 2025, but also higher volatility. And in terms of preferences, we continue to like that intermediate part of the curve, the 12 to 22 year, and we continue to prefer higher credit quality issuers.
So that in a nutshell is what we expect, but there's a lot under the hood. So let's get to it. First, let's talk about performance.
Munis have had a bit of a rally since the election. That was very welcomed by investors and are now outperforming treasuries and MBS. But the year-to-date 2% return is still fairly tepid by historical standards.
So we expect those total returns to be higher in 2025, powered mainly by carry and price dynamics playing a secondary role. But along with higher returns, we also expect volatility to be higher, and that would be driven by both tax, fiscal policy uncertainties that are being talked about in the market now as well as the reaction in the treasury market. In terms of curve positioning, the AAA curve substantially normalized in 2024, and that was the real big move in terms of Munis yields.
So we still like the 12 to 22 year portion of the curve, expecting the 17 to 22 is fairly attractive and represents the best risk-return trade-off in our view. We are a bit cautious of that long end, the 22-plus year, as long treasury yields may still experience volatility. I think as you would recall, long Munis yields, the 22-30 year, rose a lot less in 2024 than corresponding treasury yields.
So consequently, the 30-year Munis-treasury ratio has risen since the beginning of the year more than other parts of the curve, so slightly lowering that appeal of that long end. Overall portfolio effective duration of 66.5 years, right around where the index is. So that's our curve positioning and duration preference.
Let's talk a little bit about the fiscal and tax policy that's obviously being talked about a lot these days, inflation. We still expect inflation to moderate, though its resurgence is one of the primary risk factors given higher tariffs and higher deficits. Policy uncertainties will linger, and that drives my earlier point of higher volatility in 2025.
But even though all that said, we still believe final policy outcomes from tariffs and deficits will be moderated by the fiscal hawks in the Republican Party. Tax exemption is a big item. There's obviously a lot of attention on this topic.
Some types of Muni bonds may face the risk of losing the exemption. If that happens, existing bonds will likely be grandfathered. But this is an evolving topic, and we will delve into this a little more in some more detail later in this call.
Market technicals, we expect 2025 to be another strong year of tax exempt issuance in excess of $450 billion. But that will be balanced also by the strong net foreign inflows, and that's driven by the Fed easing cycle, which will overall keep demand and supply in balance. So both a strong supply and a strong net inflows is the expectation of 2025.
And within that inflows, we still expect continued growth in separately managed accounts, which has been the trend over the last few years. One of the questions we get from FAs frequently is, should my client buy Munis or corporate bonds? And just to directly answer the question, investment-grade Munis provide higher tax-equivalent yields than do investment-grade corporates, and that too with higher credit quality and lower duration.
So there are some attractive features of Munis when you feature that tax exemption into the yields. And also, Munis offer better portfolio diversification value. The correlation with equities is actually lower than what corporate bonds have with equities.
So there's some diversification value along with higher tax-equivalent yields. Finally, let's talk about credit. As I said, we continue to prefer higher-quality issuers given tight spreads on lower-quality obligors.
BBB spreads particularly are very tight in the lower quartile of the 10-year range. And while we expect the economy to stay strong, so don't expect any material spread widening in 2025, lower quality does not look very compelling from a risk-reward standpoint. So we continue to prefer higher-quality issuers.
So that was a wrap-up of our main expectations, preferences. And while we are on the topic of credit, let's talk a bit more about fundamental credit trends in the Muni market. As our audience well knows, Munis are mainly a buy-and-hold asset class, so fundamental credit trends are important from investors' perspectives.
And I'm very pleased to get my colleague Janine Lennon into that conversation. So Janine, let's talk about fundamental credit quality in the municipal space. So could you briefly describe, discuss the trends in fundamental credit quality and our outlook for 2025?
Yes, absolutely. Thanks for the opportunity to speak about Muni credit in the year ahead. And good morning, everybody.
First, I think it's important to highlight that municipal credit was largely stable in 2024, supported by a relatively strong economy, like you mentioned, which was accompanied by significant remaining pandemic aid. Notably, we expect continued stability into 2025, and we'll monitor any alterations to the Muni market by the incoming administration and possible implications on Muni credit. Now, like everyone is very aware, Munis are a highly bifurcated asset class, and it's often difficult to generalize a market that has over 50,000 issuers with 1 million active QSIPs.
That said, we try as best we can by breaking the market up into sectors and highlighting each of their outlooks into one nice table in the credit section of our publication. Breaking Muni's larger issuer – sorry, issuing sectors into nine segments, we have highlighted six as exhibiting lower risk, including airports, electric utilities, public higher ed, state government, toll roads, and water sewer, with the remaining three presenting a more moderate risk profile for investors in the year ahead, which would include local governments, private higher ed, and not-for-profit hospitals. With that, we expect a majority of municipal issuers will experience a stable operating environment, with only three sectors – water and sewer, private higher ed, and not-for-profit hospitals – encountering a more mixed outlook, given potential challenges in each of their respective sectors.
We have highlighted pertinent facts supporting those views within the table, but encourage anyone that has questions to reach out to us directly. In terms of widespread impacts on credit, outside of the sector-by-sector view, CIO acknowledges that fiscal climate risks continue to rise, governance matters are commanding more investor attention, and there is still some uncertainty regarding impacts to Muni's by a new administration, which Ted will cover a bit later. We will continue to monitor all of these consequential matters and their effects on credit quality in the year ahead.
But more broadly speaking, the uncertainty brought on by COVID into the public finance sector in 2020 was abrupt, as municipal issuers were faced with a rapid new reality which affected all sectors. Downgrades significantly outpaced upgrades. In the following years, however, swift action by the federal government, aided by a resilient economy, helped to stabilize credit quality rather quickly.
As a result, we saw upgrades meaningfully outpace downgrades in 2021, 2022, and 2023, and as we forecast in last December's year ahead, we saw that trend moderate in 2024. Looking into 2025, we expect credit quality to stabilize even further, given a more normalized economic backdrop. In our view, we expect a more even split of positive and negative rating actions in the year ahead, given issuers will be left to operate within their new means, now that a majority of federal monies have been exhausted.
So with that, thanks for having me on to discuss municipal credit in the year ahead, and I'll pass it back over to you, Siddhi. Thank you, Janine. That was a very useful description of what's going on with credit quality in the mini space.
Let me turn to Ted and talk about an important topic that I referenced in my opening comments, which is the tax exemption on mini bonds. This is an evolving topic, and not just tax exemption, but also other potential tax reform measures. So, Ted, could you provide some perspective for our audience on this rather important subject?
Certainly. Good morning, everyone. With most of President-elect Donald Trump's prior signature legislation, the 2017 Tax Cut and Job Act, set to expire at the end of 2025.
So if you remember, back in 2017, then-President Trump lowered tax rates considerably, obviously, with Congress' authority. Those are about to expire, and we're receiving a lot of inquiries about the expected form that tax legislation is going to take next year with that in mind. Given that the Republicans today, well, will be the incoming administration, Republicans are going to control both the White House and Congress, and when you look at even most Democrats not wanting to see taxes increase, at least on the lower and middle class, we are fairly confident individual income tax brackets will not rise or revert to their pre-2017 levels, that this legislation isn't just going to expire and Congress will act next year.
Extending the lower income tax rates for another ten years would increase the U.S. deficit by about $4 trillion over the next decade, according to the Congressional Budget Office or CBO. Therefore, we already know at least some Republicans are likely going to seek alternative ways to offset the cost of the tax extension to avoid exasperating the rising U.S. deficit, which is going to require some serious and tense negotiations next year. Actually, they're already underway.
So, this context explains some of the headlines about the potential elimination of the municipal tax exemption, which obviously is near and dear to our heart. The tax exemption for munis costs U.S. taxpayers approximately $51 billion in 2023 alone, so add that up over ten years, you're talking roughly half a trillion dollars, so it's meaningful. While there is some threat to the tax exemption, we view the full elimination as a low probability event, so that's worth repeating.
We do believe there is some threat to the municipal tax exemption, but we do view that full elimination of that tax exemption as a low probability event at this time, though we certainly cannot entirely discount it going away. We see it still as a low probability event. I just want to emphasize that.
With that in mind, we see private activity bonds, which is a part of the meeting market, as the most at-risk segment of this market, especially since they were considered for cuts in 2017, but ultimately were spared. So, they were on the table then, but taken back. So, this subsector of private activity bonds, this includes bonds for hospitals, higher educations, and airports, and we view private higher education out of that group being particularly vulnerable if cuts occur to the muni tax exemption, in our opinion.
But this is going to play out over time next year. Other tax provisions of interest to investors that we often get questions about include the state and local tax deduction or the SALT deduction, which is currently capped at $10,000 per individual or married couple. Given the thin majority in Congress today, especially on the Republican side, and pressure from those Republicans which reside in high-tax states, so notably New York and California Republicans, New Jersey, there's a serious effort to lift or eliminate the cap.
We doubt it'll be fully eliminated, but we do expect it to at least be raised. We've already been hearing numbers of about $20,000 or potentially more, but right now $20,000 seems to be the number for married couples. It's unclear if that would rise also for individuals to $20,000.
Since it was a major revenue source to offset 2017 tax cuts, we really doubt they can raise it a whole lot higher, or the deficit number that I mentioned up front will get significantly worse. Additionally, early discussions suggest individual alternative minimum tax levels will be extended, or AMT, as we often refer to them, will be extended and possibly made permanent. We'll see how that shakes out.
Based on statements coming from incoming Senate Majority Leader John Thune, we can expect the expiring tax provisions to be addressed in the second half of 2025. Some more to come on this as Congress hashes out their thoughts on taxes in the new year. One final note for our municipal bond enthusiasts, if we are wrong and the muni tax exemption is fully eliminated, we believe existing bonds will be grandfathered, likely increasing their value due to investor demand and diminishing supply.
That's it for me. I hope everybody has a happy and healthy holiday. I'll turn it back over to you, Sudeep.
Thank you, Ted. That was real good, solid insights into this evolving topic. Obviously more to come on this in 2025.
Let me just finish off by saying, just re-highlighting our main points for 2025, overall team being strength amid policy uncertainties. Ted just talked about the policy uncertainties. We expect higher returns, but also higher volatility in 2025.
And in terms of preferences, we continue to like that intermediate part of the curve, the 12 to 22 year, and prefer higher quality issuers. So we encourage people to take a read of our year ahead report. Well, Sudeep, Janine, Ted, thank you very much for dropping by top of the morning today to share your expectations, outlook for the municipal bond market in 2025, and do appreciate your insights and positioning guidance throughout the course of 2024 to our listeners and our clients.
I do indeed look forward to continuing with these conversations in the year ahead. In the meantime, for our listeners, our clients, as has been referenced on today's episode, the latest municipal market guide, a monthly publication, this, the 2025 outlook piece, that title again, strength amid policy uncertainties, is now available up on UBS.com forward slash CIO. Now for clients of UBS, simply reach out to your UBS financial advisor.
If you would like to receive a copy of the latest municipal market guide directly from UBS studios, I'm Dan Cassidy. Thank you for joining us. Thank you for tuning in.
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