The Upside of Munis’ Down Market


May 3, 2018 [municipal bond market, bond yields, Treasuries, Corporates]
Dominic Alto

Bond supply is plummeting, but so is demand. And rates are rising. Where are the silver linings?

After its worst first-quarter in 22 years, the municipal bond market extended its losses in April, with yields continuing to climb. Market yields rose five to 20 basis points across the curve last month, pushing all sectors of the market, excluding ultra-short strategies, deeper into negative territory.

Over the first four months of 2018, supply shrank 20% year-over-year. That should have been a boon for bond prices, but the reduction in supply has been offset by significant retrenchment in demand from banks and insurance companies following last December’s tax reform.

What now remains to be seen is how retail investors react to any further negative performance. Household sector assets now account for $1.6 trillion in municipal holdings – roughly 40% of the market – and a rush to the exits could lead to further downward pressure on prices. While painful, that could create attractive entry points for longer-term muni investors following recent years of higher-risk and lower-reward propositions in the space.

Will rising benchmark interest rates spark a muni bond fire? The U.S. Federal Reserve stayed its hand at its May 2 monetary policy meeting, and indicated it's committed to a gradual path of policy normalization through a combination of increasing the Federal funds rate and shrinking its “quantitative easing”-inflated balance sheet by allowing maturing bonds to roll off it. This could lead to more problems for fixed income, but there are a couple silver linings for municipal bond investors.

Munis have performed well so far in 2018 relative to other fixed income asset classes, including Treasuries and corporate bonds.


Munis Ahead by Being Less Behind (12/29/2017 - 4/30/2018)

Source: Bloomberg

More importantly, while a rise in rates leads to a decline in bond prices, the positive impact on income generation is often overlooked. That’s incredibly important because income is generally the largest driver of total return for fixed income investors. An actively managed, laddered strategy that judiciously reinvests the consistent cash generated by coupon payments and maturities at the far end of the ladder can be a powerful mechanism to manage a fixed income portfolio in a rising rate environment. This structure also allows investors to capture yields as rates rise, increasing the cash flow, or dividend yield, of a portfolio.

Alongside the ladder structure, the current state of the yield curve and credit spreads helps guide positioning decisions. Both would suggest a prudent strategy should focus on higher-quality and shorter-duration bonds. Indeed, ultra-short munis of two years or less are the only maturity range with positive performance. And ultra-short maturities are offering significantly more yield pick-up than they have in the recent past. Bonds of two-years and less are offering roughly 60% of the yield in the market, compared to a five-year average of 21%.

One muni-land anomaly is the high yield segment. Despite prices being at all-time highs, and credit spreads at, or near, all-time lows, investor dollars are pouring into the space. In April, even as the broad muni market experienced out-flows, high-yield munis garnered inflows. This has pushed their prices higher and buoyed performance. Whether fundamentals merit those investor dollars remains to be seen. Some individual issues may, but investor flows that indiscriminately lift one group or another regardless of fundamentals can revert awfully quickly. Diversified portfolios populated by attractively priced, fundamentally sound, selectively picked bonds tend do better both when the tide turns, and over time.


Bloomberg Barclays Muni High Yield Total Return Index (4/14/2008 - 5/2/2018)

Source: Bloomberg
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