Fixed-Income Insights
Muni Matters: Finding Value in a Strong Market
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.
A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Lower-rated investments may be subject to greater price volatility than higher-rated investments. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Investments in Puerto Rico and other territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.
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Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price.
Tax-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond in order to see which bond has a higher applicable yield.
The Thomson Reuters Municipal Market Data (MMD) AAA Curve is a proprietary yield curve that provides the offer-side of “AAA” rated state general obligation bonds, as determined by the MMD analyst team. The “AAA” scale (MMD Scale), is published by Municipal Market Data every day at 3:00 p.m. Eastern standard time, with earlier indications of market movement provided throughout the trading day. The MMD AAA curve represents the MMD analyst team’s opinion of AAA valuation, based on institutional block size ($2 million+) market activity in both the primary and secondary municipal bond market. In the interest of transparency, MMD publishes extensive yield curve assumptions relating to various structural criteria which are used in filtering market information for the purpose of benchmark yield curve creation.
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