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Market View

Tax-free income and the potential to realize higher income as interest rates rise are among the potential benefits of a managed ladder of municipal bonds.

 

Chart 1. How a Managed Ladder Could Adjust to Rising Rates
Projected yields and annual income based on hypothetical ladders of general obligation ‘AA’ rated municipal securities

Source: Lord Abbett and Bloomberg. Bond yield data based on the Bloomberg General Obligation ‘AA’-Rated Municipal Bond yield curve, as of February 28, 2017.
The charts presented do not represent the results that any particular investor actually attained. The information presented is based, in part, on hypothetical assumptions using historical data and is for illustrative purposes only and does not reflect the performance of any specific portfolio managed by Lord Abbett or any particular investment.  The hypothetical results have many inherent limitations and no representation is made that any account will or is likely to profit similar to those shown in the chart. Actual performance results may differ substantially. Changes in the scenario assumptions may have a material impact on the hypothetical results presented.
All returns and yields are gross of fees and taxes. Bonds are assumed to be held to maturity.  As bonds mature, additional bonds are purchased on the furthest rung of the ladder using those proceeds. It is assumed that bonds are purchased at par where the coupon equals the yield. "Income" refers to coupon income.
Past performance is no guarantee of future results. 
 

In previous Market Views, we spotlighted the challenging environment for municipal bonds in the last quarter of 2016. In the final few months of last year, munis faced three primary headwinds: decreased demand, increased supply, and a notable move higher in market yields. The start of the new year brought better tidings for the muni market, as investment flows into muni-bond mutual funds reentered positive territory after a streak of nine consecutive weeks of outflows totaling $25 billion, according to Citi Research. From January 11, 2016, through the week ended March 1, flows were approximately $3.5 billion, according to Lipper data.

In terms of performance, the broad muni market (as measured by the Bloomberg Barclays Municipal Bond Index) has returned 1.36% year to date through the end of February. That’s a good start coming off a return of -3.62% for the fourth quarter of 2016 and a modest gain of 0.25% for the full year.

Although conditions have stabilized as of early March, investors are still concerned about how municipal bonds might fare if the U.S. Federal Reserve (Fed) raises rates in 2017, as many expect. One could argue that as favorable economic data and signs of higher inflation continue to emerge alongside suggestive language from various Fed officials, the case for a rate hike in March has strengthened (the next Fed meeting is March 14–15). On the data front, the U.S. Core Personal Consumption Expenditures Index (PCE), the Fed’s preferred measure of inflation, recorded, in January 2017, its biggest monthly increase in five years. A strengthening labor market provides additional impetus for a hike, as U.S. employment grew by 227,000 in January (latest data available).

And as for what the Fed says, a recent run of hawkish commentary from central bank officials was capped by a speech from Fed chairwoman Janet Yellen on March 3, in which she said that that should employment and inflation data “evolve in line with our expectations… a further adjustment of the federal funds rate would likely be appropriate." The market is already bracing for a Fed tightening, in evidence that fed funds futures have (as of March 3) assigned a 96% probability of a rate hike in March, according to Bloomberg.

So, the big question for an investor may well be: How can I better position my portfolio to withstand the potential impact of higher rates in the future? We’ve discussed many options, from short-term, low-duration credit to instruments with negative correlation to Treasury bonds, such as bank loans and high-yield corporate bonds. Here, we highlight another option: the managed municipal bond ladder. (See Chart 1.)

We are not making the case that individual municipal bonds by themselves are a way to counter rising rates, although one could argue that higher rates would most likely be accompanied by an improving economy, a net positive for municipal issuers. What we would like to point out is that the structure of a laddered portfolio of municipal bonds is designed to benefit from higher future interest rates over time.

The fundamental idea of a ladder is that the investor determines a specific bond-maturity range, such as the one- to 10-year periods depicted in Chart 1. The investor then buys a bond at each maturity within that range, out to 10 years. The intent is to hold each bond to maturity. After a year passes, the “rungs” of the ladder will have shifted, resulting in the one-year bond maturing and the 10-year bond becoming a nine-year bond. As the one-year bonds come due, the maturing principal is reinvested in the longest-dated “rung” of the ladder in order to replace the original 10-year bond. This constant reinvestment in the longest “rung” acts to preserve the structure of the ladder.

What are the key benefits to structuring a portfolio of municipal bonds in this manner?   First, the approach provides a simple, fairly straightforward way to receive tax-free income. The investor would receive each year tax-free coupon interest from each bond, and then could choose to spend or reinvest the cash flow. Second, the managed ladder provides (barring bond-default scenarios) an element of clarity with respect to the price of the bonds the investor will receive, given that the bonds are held to maturity and will mature at par value.

Third, the managed ladder could position an investor to benefit from higher interest rates in the future. This becomes evident when revisiting the ladder structure discussed above. Returning to the one- to 10-year ladder example, let’s explore a simple scenario wherein yields across the municipal bond-maturity spectrum rise by 0.50% over the next 12 months. To be sure, this rise in yields may result in a negative price impact on the existing bonds, given that municipal bonds are not completely insulated from changes in interest rates. Remember, though, that in a typical ladder portfolio, the intent of the investor is to hold the bond to maturity, at which point he or she expects to receive par value, making any prior price changes less relevant. Further, the investor now has the proceeds from maturing bonds to reinvest at rates that are 50 basis points higher, thus increasing the overall annual income generated by the portfolio.

How might that play out during a sustained period of rising interest rates? In Chart 1, we lay out a scenario whereby after establishing a one- to 10-year ladder, yields continually rise by 0.50% for the next five years. Each year, as earlier “rungs” of the ladder mature, the principal is reinvested into longer “rungs” with presumably higher yields. The end result is an income stream that rises every year, with the portfolio, in five years’ time, generating roughly 80% more income relative to what it had originally provided.  (For a visual demonstration, try our interactive muni-ladder scenario tool to see how sample muni-bond portfolios may perform under different rising interest-rate scenarios.)

As simple as this approach appears, it has become much more difficult for individual investors to build municipal ladders on their own. Before the financial crisis of 2008–09, investors would simply purchase ‘AAA’ rated municipal bonds at each maturity. Today, ‘AAA’ rated bonds are much more difficult to come by, as bond insurance has been much less prevalent and bond dealers have significantly reduced the amount of municipal bonds held in their inventory.  What is more, with yields at historically low levels, ‘AAA’ rated bonds may not provide investors with sufficient income to meet their goals. Given these difficulties, investors may instead want to consider a professionally managed muni ladder, which could provide three key benefits:

  1. Professional monitoring and security selection—Note that the ladder in Chart 1 draws on ‘AA’ rated bonds, given the shrinking availability of ‘AAA’ rated munis in the current market. With the reduced supply of insured bonds, continuous monitoring and assessment of the bonds in the ladder becomes imperative. A professional manager can provide those services and then use advanced research capabilities to select appropriate replacements for maturing issues.
  2. Better inventory access—A professional manager has relationships with hundreds of muni bond dealers across the country, giving the manager enhanced access to bonds that might prove difficult for individual investors to identify and purchase.
  3. Better purchasing power—A professional manager also buys bonds in bulk, often purchasing directly from the issuer instead of in the secondary market, where most individual investors would buy them. As a result, a manager can purchase bonds at wholesale prices instead of individual retail prices.

Summing Up
For those concerned about higher rates in the future, a municipal ladder portfolio may be worth considering, as its structure is designed to benefit from such an environment over time.  Many prefer outsourcing management of their municipal ladder portfolios to professional managers in order to take advantage of their credit-monitoring ability, inventory access, and purchasing power.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

THINKING OF REACHING
FOR A LADDER?
 

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* Explore ladders with our new Muni-Ladder Interest Rate Scenario Tool.

* View our flyer to discover more about Lord Abbett's Managed Municipal Ladder portfolios.

CONTRIBUTING STRATEGIST

REPLAY OF WEBINAR

 

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Listen to a replay of our Feb. 16 webinar with portfolio manager Dan Solender and director Andy Fox about trends in the municipal bond market.

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