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Fixed-Income Insights

Unlike its taxable counterpart, the muni-bond curve has actually steepened. Here’s how that could present an opportunity for investors.

For at least one segment of the U.S. Treasury curve, the long-anticipated “I” word has become a reality. On December 4, 2018, the 3-5 year Treasury curve became inverted, with five-year rates actually moving below three-year rates for the first time since 2007, according to Bloomberg data. For its part, the benchmark 2-10 year Treasury curve recently dipped below 10 basis points (bps) to reach a multi-year low, according to Bloomberg. The moves have caused some consternation among investors, as flattening or inverted yield curves are seen as possible harbingers of recession.

But for one part of the fixed-income market, the yield curve has actually become steeper, with long-term yields remaining well above short term yields. We’re talking, of course, about the 1-30 year “AAA” and “A” municipal yield curves. Take a look at the muni curves in relation to the Treasury curve as of December 7, 2018, and you will see a striking difference.

Chart 1. Steep Thoughts: Munis Offer Higher Tax-Equivalent Yields Relative to Treasuries
Yield by maturity, as of December 7, 2018

Source: Bloomberg.  Data as of December 7, 2018. TEY=Tax-equivalent yield. Muni yields derived from maturity- and rating-specific components of the Bloomberg Barclays Municipal Bond Index. Treasury yields derived from maturity-specific components of the Bloomberg Barclays U.S. Treasury index.
Tax-equivalent yield calculation for the municipal indexes above assumes the top marginal tax bracket of 40.8% on investment income, which includes the 37.0% income tax rate and the 3.8% in Medicare tax. This tax rate does not factor in the effect of AMT (alternative minimum tax) or taxes in your individual state. Tax-equivalent yield will vary based on an investor’s tax bracket. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

What’s going on here? As I explained in a recent Muni Matters column, and again in the first 2019 Outlook roundtable video, the muni curve has steepened in 2018 largely because of reduced demand from both retail and institutional investors for longer-dated muni bonds. Retail buyers, who make up the majority of muni-bond investors, have embraced the shorter end of the market amid concerns about the pace of monetary tightening by the U.S. Federal Reserve and the possibility of rising interest rates, even though they have already risen considerably since the summer of 2016. Institutional buyers such as banks and insurance companies have been less interested in the tax exemption of municipal bonds since the tax bill significantly reduced corporate tax rates. Supply has also played a part, including effects from the enactment of tax reform in December 2017. After having a record amount of supply in December, in response to the tax bill, municipal bond new issue supply is down 17% through the end of November 2018. With less supply and heavy demand for short maturities, that part of the municipal bond market has been under less pressure than the taxable market, while the reduced long-term demand has caused the municipal bond yield curve to steepen.

That has surprised many people, who assume muni-bond rates track their counterparts in the taxable market. The upshot is that in our opinion, the higher yields currently available on muni bonds with maturities 10 years and longer may represent a compelling entry point for investors looking for attractive tax-free income. Short bonds can also be attractive if an investor’s outlook is still concerned with rising rates, but with the muni yield curve steepening, investors might find better relative value by looking out longer. We suggest you read the full Muni Matters column for further details, but here are four key points outlined in the piece:

  1. Higher interest rates have made tax-equivalent yields more attractive.
  2. Municipal bond yield ratios compared to U.S. Treasuries have risen for longer maturities, and have fallen for shorter maturities.
  3. Municipal bond credit quality has remained strong.
  4. The municipal bond market has functioned well despite recent outflows.

The final point from the October column bears repeating here: Against a backdrop of low yields around the world, fewer tax exemption opportunities in the United States due to the 2017 tax bill, and a domestic economy with steady growth and low inflation, we believe there are many reasons why it might be time to consider increasing a portfolio allocation to municipals.

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