How to Find Opportunities in the Municipal Bond Market

 

AcropolisMunicipal bonds are interesting right now after the ‘taper tantrum’ that started at the beginning of May when the Federal Reserve telegraphed its intent to taper off their bond buying program known as quantitative easing.

Actually, all bonds are a little more interesting for a few reasons. First, yields are higher. The rising rate process hurts bond prices, but we should ultimately be happy about the end of low rates. Furthermore, higher yields are better right now since inflation expectations haven’t changed, which means that ‘real’ yields are higher.

Second, the Treasury curve has steepened, meaning that long-term rates have risen while short-term rates have stayed the same. Since most bond prices are based on Treasury bond prices that means that most curves have also steepened.

Finally, credit spreads are wider, which means that the difference in yield between bonds with credit/default risk and Treasury bonds is higher than it was before the tantrum.

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The accompanying chart shows the current US Treasury curve in green to establish a baseline for the overall bond market. The blue line shows the tax-equivalent yield curve for AAA-rated municipal bonds and the red line shows tax-equivalent yields for lower rated (though still solidly investment grade) A-rated municipal bonds.

There are many sources of risk and return in the bond market, but the two biggest – by far – are term risk and credit risk (in that order).

The term premium is the difference in yield between short and long-term bonds. In this case, short-term Treasury bonds have no interest rates because the Federal Reserve has its foot on the short end of the curve.

The Fed doesn’t control long-term interest rates (okay, they influence it sometimes with things like Operation Twist), and longer-term bonds are earning almost four percent for Treasury bonds and almost nine percent (tax-equivalent) for the A-rated municipal bonds.

The difference between these short and long-term yields is known as the term premium. The higher yield on long-term bonds compensates investors for the increased uncertainty of time. While forecasting is next to impossible, we all have a greater sense of what inflation might be in the next three months compared to what we might know about the next 30 years, so a bond investor demands more yield in exchange for the longer commitment.

Should investors buy the bonds with the highest yield? Of course, it depends on their specific circumstances, but a typical total return investor should not. Notice how the yield curve flattens out after 15-years or so.

All of the term premium is backed into the first 15 years, there is not much benefit after that and we know that the interest rate risk keeps going higher as we go further out on the curve, so the risk/return tradeoff isn’t attractive past 15 years.

This unappealing risk/return tradeoff has generally been true over time. The volatility of returns rises substantially compared to the extra yield, making long-term bonds hard to justify in general. We think investors are better off investing at the steepest point of the curve, which isn’t necessarily the highest point.

The second source of risk and return, credit risk, is imbedded in both of the muni curves. In theory, AAA-rated is AAA-rated, but we can see that the AAA-rated Treasury bonds have much lower yields than the AAA-rated muni bonds, implying that the market doesn’t see the two identical ratings as actually having same risk.

Of course, we trust market pricing over ratings agencies and it’s intuitive that there would be a higher yields for muni bonds and corporate bonds compared to government bonds to compensate for the credit risk.

Now, stepping down two rungs of the credit ladder, A-rated bonds have an even higher credit premium than AAA-rated bonds, which makes intuitive sense.

Should investors buy the bonds with the highest yield? Again, it depends, but it also makes sense to buy credit when credit spreads are wide and avoid credit when credit spreads are narrow. Spreads are reasonably wide right now, although at that same 15-year mark, the spread between A-rated and AAA-rated bonds is a little narrow. It might make more sense to go a little shorter in the seven-year area where the curve is steep and the credit spreads are the widest.

The point of this article, though, isn’t to say what muni bonds to buy now, but to help look at the . The curve changes constantly and the opportunities will change too, so it’s more useful to understand how to find the best points at which the risk/return scenarios meet your objectives.

About David Ott

David OttDavid Ott is the Chief Investment Officer for Acropolis Investment Management, LLC., a St. Louis-based Registered Investment Advisor that he co-founded in 2002. Today, Acropolis manages more than $1 billion for private clients, institutions and retirement plans. You can subscribe to his newsletter, Dave Ott’s Due Diligence, by clicking here.

 

 

 

 

 

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Comments

  1. John D. says

    “The point of this article, though, isn’t to say what muni bonds to buy now, but to help look at the .” The what? Dynamics of the yield curve? It would help with understanding the last, summary paragraph if the missing words could be filled in. Thanks.

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