John Mousseau, vice chairman and chief investment officer for Cumberland Advisors, and Patricia Healy, senior vice president of research and portfolio manager, discuss the outlook for the muni market in 2025. (For the 2025 Cumberland Advisors Markets Outlook, visit tinyurl.com/4wkchr9f.)
Tax-free municipal bonds (Mousseau)
It is a particularly important outlook given the fact that we have just gone through a presidential election and have the return of Donald Trump. We are coming off a 2024 that was good for equity markets and good for bond markets up until the fourth quarter of the year, when there was a rise in inflation expectations. One of our basic investment tenets is that markets revert to the mean over periods of time, and that is reflected in our outlook here as well.
The tax-free bond market was not immune from the rise in Treasury yields witnessed in the last quarter of 2024. Tax-free yields started to rise late in the third quarter – a lot of the move based on the rise in Treasury yields associated with the Trump election betting odds.
In the third quarter yields dropped associated with a tighter presidential race once President Biden left the ticket, and in the fourth quarter the increased yield levels were consistent with the Trump rise in the polls and presidential betting pools. There was also some increase in yields after the election. The relatively strong performance of muni yields versus Treasuries during the fourth quarter stems in large part from many municipal issuers moving up their issuance slated for the last two months of the year to late September and early October. Hence, while yields were rising late in the year, there was relatively little muni supply – along with some heightened demand from December and January rollover periods.
There is no question that the Fed rate cut in early December of 25 basis points confused the markets, because the cut was accompanied by Fed comments about the outlook for increased inflation and growth. When a bond market is confused, it usually votes with its feet and treats uncertainty with a higher yield buffer, and this last month of the year was no exception. There have been many cross-currents in economic data and there has been a strong-economy narrative in the last couple of months, though there are still signs of a possible slowdown – lower manufacturing and service indices, falling credit card debt, and a drop in durable goods orders.
As we move into 2025, there are reasons to be cautious. Most are related to the new administration. It is presumed that President Trump will try to retain the tax rates from the 2017 tax bill. They would revert to older, higher rates without Congressional action; and we think this will be one of Trump’s first orders of business. Tax rates reduced from current levels could hurt tax-free bonds at the margin. Also, any drop in corporate tax rate could also hurt tax-free demand from corporations and insurance companies at the margin.
Certainly, the fallout from the hurricanes in Florida and the devastating fires in Los Angeles are raising concern about climate impacts on financial markets in general and municipal finance in particular. The benefits of diversification in muni portfolios are also reinforced by these impacts. At this juncture we have not seen a major upswing in muni yield levels. If tax-free bonds cheapen to Treasuries markedly, we would look at that as an opportunity to capture some higher yields and extend maturities.
Municipal credit outlook (Healy)
We expect the credit quality of municipal bonds to be stable as we head into 2025. The economy continues to perform well, and we now have a more normal yield curve. The Fed paused its easing of rate cuts so as not to overheat the economy. And, to some extent people, businesses and municipalities are accustomed to higher rates.
Our stable outlook is based on the high level of reserves at most municipalities, continued good budget management practices and improving pension funding levels. Stresses, such as higher wages and costs, difficulty hiring, budgeting without pandemic aid and increasing debt levels may challenge some municipalities.
The surge in muni bond issuance that we saw in the fourth quarter is expected to continue in 2025. Additional debt means leverage will increase and some operating and coverage ratios will decline. However, reinvestment in infrastructure is important to maintain the services, livability and resiliency of communities.
The LA fires, which affected and are still affecting a densely populated area, brought to the forefront the need for more resiliency in urban areas. S&P noted the need for increased insurance coverage and reserves in its multi-notch downgrade of the Los Angeles Department of Water and Power (LADWP), based on the fact that it could be held liable for the fires and how utilities were managed ahead of and during the fires. Other rating agencies took a more measured approach. Fitch put LADWP on ratings watch negative and Moody’s assigned a negative outlook. Municipalities’ preparedness for increasing climate event risks will be more of a focus going forward – which may lead to downgrades as the emphasis of the ratings analysis changes. Increasing insurance coverage and reserves could also lead to more bonding.
In addition to the LA fires, devastating hurricanes and storms in densely populated areas with lots of intensely developed real estate – we know well here on the west coast of Florida – as well as in smaller, less developed areas such as western North Carolina, will result in more bonding, too, to address recovery and rebuilding. Although disaster aid helps with rebuilding, the initial outlay of funds is borne by the municipality. Increased bond issuance is also expected for compliance with stricter water quality regulations.
The specter of taxation on municipal bonds, which has been put on a list for examination, has also led to the rush to market. We think the risk of taxation is low, as it is a relatively small revenue generator and a bipartisan issue. The status quo keeps municipal debt funding costs low and local taxes and fees lower than if muni interest income were taxable.
The new administration’s executive orders and efficiency recommendations by DOGE may also have an effect on municipal bond issuance. The timing and effect of the many potential changes could increase or decrease costs and debt issuance decisions.
There are some pockets of weakness.
Health care and higher education continue to be under pressure, given the demographics of an aging population and wage pressures.
Water and sewer’s accelerated capital spending to address aging infrastructure, asset hardening, investing in new sources of supply, and complying with increasingly stringent regulations could further pressure margins.
Public K-12 is experiencing declining enrollment because of demographics and increased competition from charter schools as well as rising costs of wages and benefits, changing state funding, and the runoff of federal pandemic aid.
At Cumberland Advisors we invest in mostly AA-rated bonds that exemplify strong and diverse economies, good financial and budget management, and strong reserves. This provides a cushion for changes and challenges that may arise.
John Mousseau is chief executive officer and director of fixed income at Cumberland Advisors. He also serves as a portfolio manager and has overall responsibility for portfolio construction, management, analysis, trading, and research for all tax-free and taxable bond accounts. Contact him at John.Mousseau@cumber.com or 800-257-7013, ext. 307.
Patricia Healy, CFA, is senior vice president of research and portfolio manager at Cumberland Advisors. She is part of a team that conducts portfolio construction, analysis, trading and research for both tax-free and taxable bond accounts. She has extensive fixed-income credit analysis experience, including working at credit rating agencies, banks and investment-management firms. Contact her at feedback@cumber.com or 941-926-6279.