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Fixed-Income Insights

As investors weigh the impact of rising U.S. Treasury yields on their municipal bond portfolios, here are four important points to consider.

 

In Brief

  • As municipal bond investors ponder the effect of rising U.S. interest rates on their portfolios, we thought it would be helpful to present four points offering some context about today’s market.
  • In short, higher rates have made tax-equivalent yields more attractive; muni-bond/U.S. Treasury yield ratios may be signaling opportunities in longer-dated munis; overall muni credit quality remains strong; and the muni market has functioned well despite recent outflows from muni-bond funds.
  • Considering the strong U.S. economy, and current U.S. tax policy, we believe there are many reasons why investors might want to consider increasing a portfolio allocation to municipals.

 

For a while, many municipal bond market participants have been predicting that interest rates would rise, so they have taken a conservative stance, buying predominantly short-maturity bonds. Since many of these investors are individuals—and according to data from the U.S. Federal Reserve, the municipal bond market is dominated by retail investors—that preference has made the muni-bond yield curve steeper than other markets. While many U.S. Treasury bond watchers have been worrying about an inverted yield curve, municipal bond investors have not had the same concerns.

Now, as of mid-October, rates have risen on a year-to-date basis, and are up considerably from their low point in July 2016. In response, many investors are trying to determine whether now is a good time to invest in the municipal bond market. As they ponder their next moves, we thought it would be helpful to present four points offering some context on where the muni market is today.

1. Higher interest rates have made tax-equivalent yields more attractive.

According to Thomson Reuters Municipal Market Data (MMD), during the first two weeks of October, yields for AAA-rated municipal bonds with maturities of 15 years and longer rose by 0.20%, while 10-year AAA muni yields were up 0.15% and 5-year AAA muni yields rose 0.10%. Year to date through October 16, yields have risen 0.77%-0.87%, 0.77%, and 0.62%, respectively.

So, for investors in a 35% tax bracket, based on the tax equivalent yield, this year’s 0.87% increase for a 30-year tax free municipal bond yield is equal to a 1.34% increase in a taxable bond.1  For those looking to put money to work today, these higher starting yields make municipal bonds increasingly attractive.

Here’s where it gets really interesting. When looking at 30-year yields, since the low point on July 6, 2016, when the AAA yield was 1.93%, rates have risen to 3.41% as of October 15, 2018. That is an increase of 1.48%. For an investor in a 35% tax bracket, the tax equivalent yield has increased by 2.28%.2 It seems counterintuitive, then, that demand for municipal bonds is actually lower now.

2. Municipal bond yield ratios compared to U.S. Treasuries have risen for longer maturities, and have fallen for shorter maturities.

A notable market dynamic this year has been that the yield of AAA-rated municipals compared to Treasuries, as tracked by Municipal Market Data, has cheapened for longer bonds, while getting richer for shorter bonds as the muni yield curve has steepened. The richest point for shorter maturities was in July, and although the yield ratio has increased since then, it is still lower than when the year started.

For 30-year issues, municipal yields as a percentage of yields for Treasuries of comparable maturity started the year at 93%, and are now at 102% (as of October 16), meaning that long municipal bond yields have risen more than Treasuries. At the short end, two-year yields started at 83%, fell to 59% in July and are now at 72%. This means that overall, short municipal yields have not risen as much as Treasuries thus far in 2018, but they have risen more since July. In our view, it’s clear that municipals have attractive relative value in the longer maturities, while valuations have neared average in the shorter maturities.

3. Municipal bond credit quality remains strong.

Typically, the municipal bond market only receives attention when there are negative headlines about issuer credit quality, such as states or municipalities whose budgets have not been agreed upon because of legislative stalemates. The market does not get as much attention when overall credit quality is doing well, which is the case now. With U.S. economic growth being steady, and unemployment rates low, state revenue collections are strong—above projections in most cases. Also, the ratings agencies have issued more upgrades than downgrades. For example, during the second quarter of 2018, Standard & Poor’s announced 324 upgrades and 204 downgrades, a very positive ratio. The only quarter since 2015 with more upgrades was the first quarter of 2018. In our view, it is clear that there is positive momentum on the credit side.

4. The municipal bond market has functioned well despite recent outflows.

The week of October 8 was challenging for municipal bond investors, but, by most metrics, the market responded well. According to Lipper, between October 4 and October 10, municipal bond mutual funds recorded $769 million of outflows. This was after inflows of approximately $11 billion cumulatively during the prior weeks of 2018. The jump in outflows meant some busy trading activity for portfolio managers as they raised cash to cover investor redemptions.

One measurement of the tone of the market is how many bonds are put out for bid on Bloomberg. For 2018, on average, the total par value of “bid wanteds” (i.e., instances where bond investors put bonds up for sale) has been $840 million per day. The daily average for the week of October 8 was $1.3 billion. The total par value of bonds being traded per day during 2018 (through October 16) was $12 billion, according to the Municipal Securities Rulemaking Board. During the week of October 8, the average was $14.7 billion.  While yields increased a little, and prices were down somewhat, the downward market move, as represented by the Bloomberg Barclays Municipal Bond Index, was well under 1% in total return for the week.  So despite previous concerns about the cost and availability of liquidity in the municipal bond market, this response was more than adequate.

Summing Up
The recent volatility and interest-rate increases have put some pressure on municipal bonds, but the market has responded well, and market movements have created some positive dynamics that investors should consider. For example, with yields rising, tax-equivalent yields are much more attractive, ratios of municipal yields to Treasury yields are more attractive for bonds 10 years and longer, while shorter maturities are now less richly valued than they were a few months ago. Municipal credit quality continues to be strong amid a robust U.S. economy. Finally, the municipal bond market is much more mature and active than it used to be, and has demonstrated that it can comfortably handle increased trading volumes. Considered 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.

 

1At the 32% tax bracket, the tax-equivalent yield gain would be 1.28%; at 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, the tax-equivalent yield gain would be 1.47%. Tax rate calculations do 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.

2At the 32% tax bracket, the tax-equivalent yield gain would be 2.18%; at the top marginal tax bracket of 40.8%, the tax-equivalent yield gain would be 2.50%.

 

About The Author

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