It has become a tale of two bond markets — Treasurys and municipal bonds.
Much has been made of the flattening Treasury yield curve and what that portends, including a possible recession.
But the muni bond market's yield curve has been steepening—meaning that yields on longer-term bonds are rising relative to yields on shorter-term bonds. That's potentially creating attractive value for longer-dated securities.
AAA-rated 15-year munis were yielding about 2.7% recently, up from 2.2% late last year. The yield on two-year AAA municipals was a shade below 1.7%.
That's a spread of about one percentage point, or 100 basis points.
In contrast, the recent spread between 15- and two-year Treasuries was 29 bps—2.95% versus 2.66%.
Justin H. Hoogendoorn, head of fixed-income strategy and analytics at Piper Jaffray, says that the last time the muni curve was this steep was in 2000. Yields fell sharply after the dot-com bubble burst. (Bond prices and yields move in opposite directions.)
Hoogendoorn attributes the steeper muni curve to two main drivers.
Institutional investors, notably banks and insurance companies, have been less likely to buy these securities, he theorizes, owing to last year's federal tax-overhaul package. The corporate tax rate is now 21%, down from 35%. The interest on muni bonds is typically exempt from federal taxes and, in some cases, state and local taxes. But the lower federal corporate tax rate could make municipal bonds less attractive because the tax savings are reduced.
Hoogendoorn also ascribes the steeper muni yield curve to the Federal Reserve's steady regimen of interest-rate hikes since late 2015. That, he wrote in a note this week, has created a "fear in the retail community that rising overnight rates will automatically push long-term rates higher and consequently drive down prices on their bond holdings."
All of this has pressured longer-term muni-bond prices and pushed up yields. This arguably has created some value in that pocket of the market.
"We think it's attractive, especially relative to the Treasury curve," asserts Hoogendoorn.
Why bond funds are thriving
John Miller, head of muni bonds at Nuveen, points out that the muni market is bifurcated. For munis with maturities of fewer than 10 years, there has been lower supply and higher demand. The opposite has held true for longer-dated issues, he says.
The long end of the muni curve, he adds, has gotten cheaper, as evidenced by the higher yields, "but it hasn't really moved very much" this year.
For Treasury investors, the shorter end of the curve does offer advantages. The two-year Treasury was recently yielding 2.67%, not far below the 2.91% for the 10-year bond, and there's less duration risk at the front end of the curve if rates ever spike.
One investing approach under these circumstances is to combine shorter-term fixed-income holdings, including Treasuries and floating-rate bonds, with longer-term munis.
Hoogendoorn favors blending such munis—including those with 15-year maturities—with a shorter-duration taxable bond portfolio that includes floating-rate products, some of which yield at least 3%.
He expects more individual investors to get back into the muni market by the end of the year, "when it becomes more obvious that the Fed is very near the end of its hiking cycle."
It's important to have a balanced portfolio to protect against a spike in interest rates, which would pressure bond prices, particularly at the long end. But some exposure to longer-dated munis as part of a larger portfolio looks sensible right now.
As of July 31, the $8.7 billion BlackRock Strategic Municipal Opportunities fund (MEMTX) had a big weighting in bonds with maturities of at least 15 years. The fund places at or near the top of its Morningstar category based on one-, three-, five-, and 10-year returns. Its three-year annual return of 4.72% beat its category average by more than two percentage points.
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