There are attractive opportunities in the municipal bond market. Our portfolios exhibit strong yield and less duration compared to many intermediate municipal bond benchmarks, ETF’s and mutual funds*. Currently, we aim for real yield net of inflation and wisely position for 2-3 year interest rate outlooks. Many investors believe attractive positioning in the bond market is unattainable because of rising interest rates. If you are in this camp, our guidance warrants your attention.
The municipal bond market provides compelling relative value, more than we see in other U.S. based bonds. A-AA rated municipal bonds provide better yield than weak B-BBB corporate bonds on a TEY basis. Our definition of relative value is after tax yield earned per unit of risk as measured by interest rate and default risks. Tax equivalent yields (TEY’s) on A–AA rated municipal bonds are 5.00%-8.00% with intermediate duration callable municipal bonds. For comparison, the Thomson Reuters BBB corporate bond credit curve indicates 5.00% yields are reached only with 15-20 year maturities, or 5.00% yields could be earned based on their BB corporate curve in 1-2 years...with a 16% default rate. To hit the upper end of the 5.00-8.00% TEY range provided by intermediate callable municipals, the BB corporate curve in 30 years won’t even get you there, you would need 2-3 year single B corporate bonds which carry dizzying default rates of 36%. (Sources: Thomson Reuters USD credit curves; Moody's default analysis, 6/24/17).
Based on our definition of relative value, we do not see an asset class that provides as much relative value as investment grade municipal bonds out of the complete set of U.S. fixed income markets. What investors overlook or misread is strongly-rated A-AA municipal bonds, with default rates of 0.02% and 0.07% respectively (that’s 2/100ths of one percent and 7/100ths of one percent, respectively … negligible in practical terms) can yield the same 5.00-8.00% TEYs as B-BBB corporate bonds. Why would one look elsewhere for fixed income investments? We read this as a very strong indication of value in the investment grade municipal bond market.
The topic outstanding is how to position a portfolio to target real returns and address rising rates. We recommend allocating to 2-4 year maturities with sub 5% coupons and 15-20 year maturities with 4%+ coupons and calls in the early 2020s. This type of portfolio is well-positioned for both stable and rising interest rates, both scenarios we could face in the next 24-36 months. We recommend A-AA ratings on average. AAA rated bonds charge too much quality premium. We recommend a third in well-rated GO's and two-thirds across a few revenue sectors.
Opportunistic and defensive describe our feelings about this market. Our guidance is opportunistic reflecting our goal to generate real yield net of inflation. We are also defensive given upward pressure across treasury and municipal bond yield curves. The U.S. economy appears stable with moderate growth rates, inflation at the Fed’s 2% target, and unemployment at a generational low 3.9%. The Fed is likely to raise the their target rate 2 more times this year, perhaps 3, and may continue in 2019. The Fed is unwinding its balance sheet while the federal government is undertaking huge deficit spending projected at well-over $1 trillion annually. These factors are creating upward pressure on the entire treasury curve, with excess pressure applied by the Fed on the short end. This is likely to continue flattening the 2-10 year treasury spread, currently at just 42 bps, down from 77 bps in February (source: Thomson Reuters). We also factor in market surprises that may harm portfolios. Key risks are an inflation surprise to the upside, heavy deficit spending strongly impacting U.S. treasury rates, and the Fed’s balance sheet reduction strongly impacting U.S. rates. Our guidance of short and intermediate callable bonds works well in scenarios that see these risks realized, while positioning for real yields today.
Investors are uneasy as they don’t know how high rates will go, they don’t correctly calculate the impact of a 50 - 200 bps rise in key rates over 2-4 years. Ultimately many remain in cash losing to inflation. Based on our calculations and portfolio guidance, even a 200 bps shift up in key yields over the next 3-4 years can result in positive yields higher than today’s inflation levels.
Maintaining your purchasing power is vital to maintaining your financial strength. We are available to review your portfolio(s) and make recommendations based on our guidance and your investment goals. Please visit us on our website at www.mcmunis.com for ideas and to sign up for our blog. Also, call or email us anytime, you will speak directly with a portfolio manager.
Greg Lavine, CFA, CFP®
* BofA ML Municipal Master Index, ITM, MUB, VWITX, MDNLX, PMNIX