Franklin High Yield Tax-Free Income Fund, Q2 2024

Performance evaluation

The municipal bond (muni) market, as measured by the Bloomberg Municipal Bond Index, posted modest negative total returns for the second quarter of 2024 and fared worse than the duration-matched U.S. Treasury bond (UST) with negative excess returns. Over the period, investor sentiment ranged from cautious in light of hawkish comments from the U.S. Federal Reserve (Fed) to optimistic as disinflation was seen to resume in April and May. The Fed kept its policy rate unchanged over the period, despite the two softer inflation data, and revised its median rate projections to show only one rate cut in 2024. Against this backdrop, demand for municipal bonds was robust throughout the quarter, even in the face of increased supply of new tax-exempt bonds, as it appeared that many issuers were seeking to finalise bond sales ahead of potentially higher volatility ahead of the US presidential election. Revenue-related issuances posted positive absolute returns and outperformed general obligation ('GO') bonds over the period. From a ratings perspective, lower-rated securities outperformed their higher-quality counterparts as spreads between the lower-rated groups continued to narrow this year.

Quarterly Key Performance Factors

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Overall, duration positioning contributed to the funds' relative performance during the second quarter. Yields rose across most maturities and so our underweight in municipal bonds with maturities between two and five years lifted results. However, an overweight in municipal bonds with maturities of 10 or more years dampened relative returns. Rating allocations drove the funds' relative performance during the period, led by our overweights in bonds with no external credit rating and those rated below investment grade. This was only modestly offset by an underweight in A-rated issues, which hampered returns. Selection across rating categories, particularly in BBB-rated securities, benefited results.

Perspectives and strategy

Financial market sentiment was mixed throughout the quarter. At the start of the period there were persistent price pressures and a relatively hawkish stance from the Federal Reserve. However, sentiment improved somewhat with two weaker inflation figures and data pointing to a weakening US economy, which was seen as supporting the possibility of earlier rate cuts by the Federal Reserve. This mixed picture weighed on the performance of tax-free municipal bonds during the quarter. However, technical supply and demand conditions were positive, as new issuance was strong and fund inflows positive. Anecdotal evidence suggests that this trend may continue, as asset allocators still hold high balances of cash and cash equivalents that they are beginning to reallocate to the sector, and especially if compelling opportunities arise. Municipal bond yields remain at historically elevated levels and may be particularly attractive to those investors seeking tax-adjusted returns. An important catalyst we are looking at for capital inflows to pick up more significantly is the flattening of the inversion of the U.S. Treasury yield curve and a return to its typical upward-sloping shape. Looking ahead, falling yields (as the Fed begins to ease monetary policy) should provide a tailwind for bond investors in 2024. Municipal market fundamentals remain stable and should be supportive for the asset class over the medium to long term. We have likely reached the peak of the credit cycle, where rating upgrades significantly outnumbered downgrades. Looking ahead, the credit environment is projected to normalize over the next year or more, although continued economic stability and improving financial positions should fend off a sharper deterioration. State and local governments have many tools to address potential challenges, particularly because they still have large “rainy day” funds that were bolstered by federal COVID-19 relief, increased during the pandemic recovery, and maintained by conservative budgeting and fiscal discipline. However, a disciplined fiscal approach will remain crucial to deal with slower revenue growth, runoff from COVID-19-related relief, rising expenses, and higher borrowing costs. While we are not concerned about a sudden spike in defaults, worsening macroeconomic conditions will mean that rigorous bottom-up research and strong security selection will be particularly important to find those credits that have the potential to outperform across market cycles.

In the US, while the economy continues to show signs of resilience, we see that growth risks are increasing. At the same time, upside risks to inflation are far from having abated. There are signs of consumer weakness, as real disposable income per capita has stagnated over the past year, and recent corporate earnings reports indicate that consumers are prioritising essential spending over discretionary spending. Furthermore, while household wealth has remained resilient, the labour market is normalising from its recent tight levels, and employees are becoming cautious about their job prospects. In terms of inflation, we see idiosyncratic factors and catch-up effects driving the core indicator in particular. The Fed will continue to look for evidence of a sustained downward movement in inflation before it can embark on monetary policy easing. This, in turn, may cause some spread volatility in the near term. In our view, such cases may potentially provide an attractive entry point into the tax-exempt municipal bond market. We believe there are opportunities to find value within the sector across the credit spectrum.