When Municipal Bonds Show Their Wild Side
Bottom-up credit research within a flexible, laddered municipal bond strategy can help tame interest-rate risk and capitalize on market volatility to protect capital and grow income.
Municipal bonds are no longer boring fixed income investments. Lately, wild and unpredictable might be more fitting descriptors. The extreme gyrations in muni prices and yields over the past few months have been dizzying. Financial advisors seeking to mitigate interest rate risk while earning tax-free income should consider an actively managed municipal bond strategy that combines rigorous, relative value credit research within a flexible laddered approach.
Record inflows despite unknowns
COVID-19 has brought the U.S. economy to its knees, infecting the municipal credit market with uncertainty as mandatory closures force many municipalities into shutdown mode—no conventions, no sports, no tourism—casting a dark cloud over the repayment prospects for muni debtholders. Yet, relatively attractive yields and the quest for income have led to robust demand for municipal bond funds. The 10-year AAA Muni normally trades at a discount to the 10-year U.S. Treasury (see chart below). For most of this year it has traded at a premium. The U.S. Federal Reserve has increased the appetite for munis by stepping in to lend to troubled municipalities via the Municipal Liquidity Facility. Many investors appear to believe the Fed’s intervention has created a muni market version of the “Powell Put,” providing a potentially false sense of security and enticement to venture further out the risk spectrum. Buyer beware.
How low can yields go?
The record-breaking inflows have driven up muni prices, sinking yields to historic lows. It’s been a wild ride. The 10-year AAA Muni went from 82 basis points (bps) on March 9, to 288 bps on March 23rd to 69 bps on July 29, a record low and a swing of 424 bps in roughly four months. Other maturity tenures have experienced similar swings.
A nimble approach and a flexible ladder for durable income in all rate environments
Thorough bond-by-bond research and nimble portfolio management that employs an active laddered strategy can help provide attractive tax-free income in today’s low-rate, highly volatile market. Finding mispriced relative values amid record low yields is crucial. It’s also critical to selectively stagger the portfolio’s bond maturities so that inflows from coupons and maturing issues are judiciously– rather than mechanically– invested in select rungs of the ladder, ensuring that any pick-up in yield at the farther end of the ladder is worth the market price risk.
An actively laddered portfolio mitigates interest rate risk by maintaining selective exposures across the yield curve, actively over- and under-weighting maturities where it pays to take a bit more risk or is prudent to take a bit less. Although it usually makes sense to reinvest maturing bond proceeds at the longest end of the curve to capture prevailing interest rate levels, in volatile markets it may make more sense to reinvest proceeds in varying maturities that represent better relative values.
Over time, assuming bonds are bought at favorable prices and held to maturity, above-market yields can be achieved. A key structural advantage of the flexible ladder is that it allows investment teams to avoid forecasting interest rate changes and instead focus on what matters most: credit research.
Record low yields and uncertainty in municipal credit markets make it difficult to wrangle attractive levels of income at acceptable levels of risk. However, a nimble manager who employs an actively laddered strategy can step to the challenge.