By James Kochan, Chief Fixed-Income Strategist
- Because municipal yield curves are exceptionally steep, we believe that the best values now are in the intermediate and longer maturities.
- Municipals are also exceptionally cheap versus corporate notes and bonds, in my view.
- While every interest-rate cycle is different, the experience of 2004 to 2006 serves as a reminder that often, the first cyclical rise in bond yields has been the most brutal.
The recent rise in municipal market yields has rekindled bad memories of the now infamous 2010–2011 market sell-off. Late in 2010, Treasury yields began rising sharply, and municipal yields rose almost as rapidly. Starting at the turn of the year, however, a credit scare sent municipal yields even higher, and they stayed high through most of the first quarter of 2011. This year, Treasury yields began rising in early May, and municipal yields rose apace. They rose even further after Detroit filed for bankruptcy in July. The size of the increase in municipals thus far this year is almost exactly what it was from 2010 to 2011, when yields on 10-year AAA municipals increased approximately 130 basis points (bps; 100 bps equals 1.00%). Yield increases on the 30-year maturities were around 125 bps from 2010 to 2011 and again in 2013.
The sharp jump in yields created an excellent buying opportunity in 2010 and 2011 because from mid-2011 through 2012, the municipal market rallied strongly as yields on the 10-year and longer maturities declined as much as 200 bps. We believe another rally of this type is unlikely, as the Federal Reserve (Fed) is expected to start reducing its monetary stimulus in the months ahead. Nevertheless, a variety of metrics suggests that municipal bonds now offer excellent long-term investment value.
The best values in municipal fixed income
Because municipal yield curves are exceptionally steep now, we believe the best values are in the intermediate and longer maturities. The 10-year to 1-year yield spread for AAA municipals is now 285 bps, far above the 165-bp average since 1990. At 130 bps, the 30- to 10-year yield differential is now almost double the average from 1990 through 2013. Thus, the slope of the full yield curve, from 1 to 30 years, is more than 150 bps greater than the average for the past two decades. This means that yields on 10-year and longer maturities are some of the highest in recent years. Indeed, over the past four years, they have been higher only in the few months of the 2010–2011 market tailspin.
Steep curves have often helped the longer maturities withstand the eventual cyclical rise in short-term rates. For example, curves were steep as the Fed began raising the federal funds rate (that is, the rate that banks charge each other for the use of federal funds) in 2004. By 2006, when the rate reached 5¼%, curves had flattened, as they almost always do as short-term rates rise. In 2006, yields on 30-year municipal bonds rated AAA and A were around 4¼% and 4¾%, respectively. Today, those yields are around 4½% and 5½%—higher than they were at the end of the last Fed tightening cycle—and the federal funds rate is not expected to start rising for at least another year.
Relatively generous yields might also help the municipal market withstand additional increases in Treasury yields. Yields on municipals rated AAA with maturities beyond five years now yield more than comparable Treasuries. For municipal bonds rated less than AAA, all maturities yield more than Treasuries. For example, in the 30-year maturities, AAA municipal bond yields are around 1.15 times Treasury yields. Prior to 2008, that ratio was in the range of 0.80 to 0.90. If the ratio were to fall back to 0.90, the current 30-year municipal yield could coexist with a Treasury yield almost 50 bps higher than it is today. Single 30-year municipal bonds with an A rating now yield 1.40 times the yield in the Treasury bond, versus a precrisis average of 0.95. Even if that ratio were to fall back only to around 1.10, today’s yields on long A rated municipal bonds could coexist with a 5% yield on the Treasury bond.
Generous yields compared with taxable investment-grade bonds
In our view, municipals are also exceptionally cheap versus corporate notes and bonds. For 10-year credits rated A, both municipal and corporate bonds yield around 3¾%. Normally, this municipal-to-corporate yield ratio is in the 0.70 to 0.80 range. To an investor facing a 30% marginal tax rate, a municipal bond yield of 3.75% is equivalent to a taxable yield of 5.20%. In the 30-year maturity segment, corporate yields rated A are around 4.90%, while municipals yield 5½%. Investors paying a 30% tax rate would need a yield of almost 8% to match the after-tax return of long municipals with an A rating. An investor would need to go to the junk bonds with a CCC rating to find yields above 8%. By virtually any metric, municipal yields are unusually generous versus yields in the taxable investment-grade markets.
The tendency for yields to jump at the first hint of a shift in Fed policy
It is not unusual for municipal bond yields to jump sharply at the first hint of a shift in Fed policy. In the weeks before the Fed began tightening in 2004, yields on long municipal bonds rose almost a full percentage point. As the federal funds rate started to rise, however, yield curves flattened to the extent that bond yields were lower in 2006 than they were in 2004. While every interest-rate cycle is different, the experience of 2004 to 2006 serves as a reminder that often, the first cyclical rise in bond yields is the most brutal. Yields close to 4% on 10-year A rated municipal bonds and above 5% on 30-year issues are some of the highest since the financial crisis. They are also well above Treasury yields and are equal to or higher than yields on A-rated corporate bonds. In my view, those yields mark the 10-year and longer municipal bond maturities as excellent long-term investment values.