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Fixed-Income Insights

Even with a steepening muni yield curve, we believe there are attractive opportunities among tax-free municipal bonds.

 

In Brief

  • As the municipal bond yield curve has steepened in recent weeks, yield ratios between AAA-rated munis and U.S. Treasuries of comparable maturities have continued to decrease.
  • Nonetheless, we believe investors can still find attractive relative values in the muni market, especially among longer-maturity bonds.
  • Though yield ratios for shorter-dated munis remain low, these securities also remain appealing when considering their tax-equivalent yields.
  • Given recent tax-law changes, we believe the tax-free income offered by municipal bonds across the maturity spectrum merits careful consideration by investors.

 

With the municipal bond yield curve steepening over the past year—in contrast to the flattening U.S. Treasury curve—some interesting valuations have arisen for muni investors. Market analysts typically look at the yield ratio between AAA-rated municipal bonds and U.S. Treasury securities of similar maturity to determine relative value. For most of the past year, ratios for bonds with maturities five years and shorter have been low, meaning that municipals have been outperforming Treasuries in that range (a lower ratio means that municipal bond yields are low compared to Treasuries).

During the first two months of 2019, the 10-year maturity ratio has moved even lower. As of February 28, 2019, the ratio for Thomson Reuters Municipal Market Data’s (MMD) 10-year benchmark yield for AAA-rated munis was 78% compared to 10-year U.S. Treasury notes. This is well below the one-year average of 84%, and the lowest the ratio has been in many years.

In response to the current rate environment, one question we are frequently asked is, “Where are you finding value in the current market?” Here, we share some of our thoughts on the topic.

Should Municipal Bond Investors “Go Long”?
The steepening muni yield curve means that long rates are high compared to intermediate and short rates.  For example, according to MMD, the spread between five- and 30-year AAA-rated bonds was 1.31% as of February 28, while the spread between 10- and 30-year bonds was 0.88%. This means that investors can pick up a lot of extra yield by extending maturities with municipal bonds. That is not the case with Treasuries.  In the Treasury market, the additional yield from 5 to 30 years was just 0.57% as of February 28, and the pickup from 10 to 30 years was 0.37%.

The difference likely stems from the composition of the muni market, as it is dominated by individual investors. These investors typically are averse to taking on interest-rate risk, and have tended to favor shorter maturities. While extending maturities leads to increased volatility, we believe there is a lot of income and potential total return available for those willing to make the move, suggesting that there is attractive relative value to extend beyond intermediate maturities.

That said, investors may still find munis with maturities 10 years and shorter attractive, because even with the yield ratio for 10-year bonds being only 78%, the tax-equivalent yields are still reasonable. For example, the 10-year AAA municipal bond benchmark yield as of February 28 was 2.10%. On a tax-equivalent basis, this is equal to a 3.50% yield on a taxable product for investors in a 40% tax bracket. A 30-year Treasury yield at that date was 3.13%, with a lot more volatility, while a 10-year Treasury yielded 2.76%, so shorter-dated municipals can still be viewed as attractive despite the low yield ratios. Of course, those who found themselves with a higher final tax liability for 2018 because of the $10,000 limit on deductions for state and local taxes might benefit from the extra tax-free income available from municipal bonds across the maturity spectrum.

And that brings up our final point: The impact of munis’ tax-exempt status is bigger than many realize. Municipal-bond yields are tax exempt at the federal level, with some issues also exempt at the state and local level in states such as California and New York. So, the extra 1.31% muni-bond yield gained from extending from five to 30 years mentioned above is equivalent to picking up 2.18% more in a taxable bond product for an investor in whose tax bracket is 40%. In our view, not only is the muni-bond market more attractive for longer-term yields than Treasuries on an absolute basis, it is even more so when making the adjustment for tax rates.

Summing Up: Muni Bonds and Relative Value
The steepening municipal bond yield curve has led to an environment where relative value appears to be most attractive for longer-term bonds, but given tax-equivalent yields, we think that all maturities of municipal bonds can still be viewed as being good investments. It is a sign of the current overall strength of the muni market that, based on industry mutual-fund flows reported by Lipper, both longer-dated bonds and shorter maturity securities are seeing strong interest from buyers. It is up to investors to determine whether they are comfortable with the incremental volatility they would have to take on to move out to the maturities that we believe represent the best relative value. 

 

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About The Author

RELATED FUND
The National Tax Free Fund seeks to deliver a high level of income exempt from federal taxation by investing primarily in investment grade municipal bonds.
RELATED FUND
The Lord Abbett High Yield Municipal Bond mutual fund seeks to deliver income exempt from federal income tax by investing in lower-rated municipal bonds.

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