Four Reasons to Consider Intermediate Municipal Bonds | Lord Abbett
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Fixed-Income Insights

This maturity segment of the municipal bond market offers the potential for more favorable risk-adjusted returns than longer munis and higher yield ratios than short munis.

Read time: 4 minutes
 

Based on Lipper data, the largest asset category for professionally managed municipal bond products is intermediate-term funds. Since we have just been through a volatile period for municipal bonds, we think now is a good time to review why this category gathers the most assets—and assess relative value for bonds in this maturity range. Here are four observations:

1.  Lower Volatility than Longer-Dated Munis

One reason for intermediate bonds’ popularity is that they have historically had lower volatility than long bonds while providing attractive yields. The Bloomberg Barclays Municipal Bond Index features different subindexes for each maturity range. We can use the 10-year index as a proxy for intermediate bonds and the 22+ year index to represent long bonds. In our view, modified adjusted duration, which includes the values of the options for bond calls, is the best measure of interest-rate risk to use. As of May 28, the duration for the 10-year index was 5.24 years while the long bond index was 9.42 years. The simple way to think of these numbers is if rates go up by 1%, the value of bonds in the 10-year index would fall approximately 5.24% while the long index would fall 9.42%.

If investors want to maximize yield with long bonds, they have to accept this potential volatility. While longer munis continue to see significant buying interest too, the larger flows going into intermediate funds (based on Lipper data) suggest that many investors have decided to sacrifice some yield to reduce their risk.

2.  More Attractive Yields Relative to U.S. Treasuries than Shorter Bonds

An investor can potentially lower risk by going into shorter bonds, but that requires giving up yield. Also, the ratio of ‘AAA’-rated municipal bond yields to Treasury yields typically is lower for shorter bonds than intermediate or longer bonds. The historical average of the five-year ratio is 81% while the 10-year ratio is 86%. There is also a higher standard deviation in short term munis’ yield ratio, meaning that it can fall to the 60% range at times while the 10-year ratio does not drop that low.  This indicates that intermediate bond yields typically are higher compared to Treasury bonds of the same maturity, so they could be viewed as having better relative value than short-term munis.

3.  More Favorable Risk-Return Characteristics

Another factor that argues in favor of intermediate munis is the attractive risk-return ratio–the amount of yield an investor receives as a ratio to the amount of interest rate risk they are getting. In simple terms it can be thought of as the yield on the bond divided by the duration. The municipal bond yield curve is typically steepest in the range from one to 20 years and then becomes flatter beyond that range. This allows for a relationship where the amount of extra yield for each extra year of maturity gets smaller on the long end while, for shorter maturities, the amount of yield is not as great compared to its duration. Based upon our internal analysis, right now the best years for risk return trade-off are 12- and 13-year maturities. The next best are a virtual tie between six-year bonds and 22-year bonds.

 

Figure 1. Intermediate-Term Munis Feature Highest Risk-Return Ratio in Maturity Spectrum
Risk-return for ‘AAA’-rated municipal bonds by maturity as of May 26, 2020

Source: Thomson Reuters Municipal Market Data. Data as of May 26, 2020. In this case, risk-return ratio refers to the amount of yield an investor receives as a ratio to the amount of interest rate risk they are taking on, as measured by duration, which is the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

4.  Higher Expected Returns Than Other Maturities of Municipal Bonds

A fourth argument for intermediate munis is that some of the highest expected returns are in this range of the yield curve.  A big part of our investment process is to identify and select the maturity combinations that have the best expected returns.  A simple starting point is to examine what the yield curve looks like today and then assume nothing changes and bonds just roll down to the next maturity the following year. For example, a 15-year bond becomes a 14-year bond. If the yield on the 15-year bond is 2% now and the current difference between 14- and 15-year bonds is 0.05%, then a year later the bond becomes a 14-year bond with a yield of 1.95%. The next step is to calculate what the bond price would be a year later with the lower yield. Then we add the coupon and the change in price percentage and that gives us the expected total return for the year.

Right now, with the yield curve being steepest in 12- to 13-year municipal bonds, the roll-down is the greatest in that range and when adding the coupon, those maturities have the best expected return. While this may seem as if it comes to the same result as the optimal risk-return trade off, the differences become apparent in other maturities. For example, the six- and 22-year bonds had similar risk return tradeoffs, but in expected absolute return the 22-year maturity is about 0.70% higher so, in maximizing returns, it is no contest in selecting between the two maturities.

 

Figure 2. Expected Returns Suggests Attractive Value in Intermediate-Term Munis
Expected return by maturity as of May 26, 2020

Source: Thomson Reuters Municipal Market Data. Data as of May 26, 2020. In this case, expected return uses current yield differential of maturities along the spectrum to calculate future prices for bonds based on the lower yield as the issues move one year closer to par.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Turning to relative value, a standard viewpoint is to examine AAA municipal bond yields compared to Treasury bond yields. Since we are focused on intermediate bonds, we can look at the ratio of 10-year yields. Right now the ratio of Municipal Market Data’s 10-year ‘AAA’-rated municipal bond yield to 10 year Treasuries is 129%. This means that before taking into account the benefit of the tax exemption, municipal bond yields are already higher than Treasury yields with the same credit rating.

It is important to remember that these are benchmark yields for municipals. When we are buying bonds for our portfolios, it would be very rare for us to not buy bonds at yields that are materially higher than AAA yields. As of May 29, the 10-year AAA municipal bond yield is 0.84% while the 10-year Treasury yield is 0.65%. Remember, Treasury bond yields are taxed at the federal level but municipals are not. So if someone is in the 35% tax bracket, the tax-equivalent yield for the AAA municipal bond is 1.29% which is still low, but a good amount higher than the 10-year Treasury. This tax equivalent yield can be higher for bonds in states where the municipal bond income is also exempt from state income taxes.

 

Figure 3. Though It Has Pulled Back, 10-Year AAA Muni/Treasury Yield Ratio Remains Elevated
Yield on 10-year ‘AAA’-rated municipal bonds as a percentage of 10-year U.S. Treasuries, September 21, 2009–May 28, 2020

 

Source: Thomson Reuters Municipal Market Data. Data as of May 28, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

It is important to consider whether 129% is high or low in comparison to historical levels for the relationship between municipal bond yields and Treasuries. As previously mentioned, the historical average is 86% so the municipal bond yield is much higher compared to Treasuries than it has typically been. During the height of the market volatility in March, this ratio touched over 300%—higher than levels reached in the 2008-09 credit crisis. With the recovery in the muni market, the yield ratio has moved lower, but we believe it still represents attractive value.

Summing Up

Intermediate-term muni funds represent the largest weighting of assets in municipal bond mutual funds.  The reasons for their popularity are understandable, as they:

  • Have had lower volatility than longer muni bonds,
  • feature more attractive yield ratios versus Treasury bonds than shorter muni maturities,
  • have attractive risk/return characteristics, and
  • typically have high expected total returns due to the steepness of the yield curve.

Right now the ratio of municipal bond yields to Treasury yields is well above historical averages suggesting that tax-equivalent yields present attractive relative value. As always, investors must make decisions regarding whether to target yield or total return and how much risk they want to take. While municipal bonds have been recovering well from the March downturn, we think there are still intriguing opportunities to consider as the market continues to rebound.

 

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