How Can Muni Investors Capitalize on Yield Curve Conditions?>
Historically, the inversion of the yield curve has been a precursor to shifts in economic conditions and monetary policy. While the U.S. Treasury yield curve remains inverted, we believe that the spread between 2-year and 10-year yields (the “2s/10s”) peaked in June 2023.
Opportunity Knocks: Spread Between 2-Year and 10-Year Yields Appears to Have Peaked in June 2023
US Treasury 2s10s Spread
Source: Bloomberg, as of 2/29/2024.
Meanwhile, the intermediate portion of the municipal bond curve has experienced a recent re-steepening. Notably, the “5s/15s” spread has surpassed its 5-year average level.
Steepening Intermediate Muni Yields Present an Additional Opportunity
Muni AAA Curve Spread (in bps)
Source: Bloomberg BVAL AAA muni curve, as of 2/29/2024.
Given the current dynamics of the yield curve, we believe these two tactical allocations can help municipal bond investors capitalize on the current environment ahead of the Fed's potential easing cycle:
- Barbell strategy that includes both short-term and long maturity municipal bond portfolios to limit reinvestment risk and increase yield without extending duration.
- Roll down strategy that takes advantage of the recent re-steepening of the intermediate portion of the municipal bond curve.
Barbell Strategy: A Flexible Approach to Capture Higher Yield (Without Increasing Duration)
Historically, during the reversal of an inverted yield curve, short-term yields fall faster than long-term yields. However, investors should be aware that the price appreciation on short-term bonds may be impacted by lower interest rate sensitivity, while longer-duration bonds are expected to achieve much larger price gains.
However, in the current economic environment, marked by concerns about inflation and uncertainty around the timing of the Fed's potential pivot, flexibility is an important tool.
Barbell strategies that allocate to both short-term and long-term maturity municipal bonds help investors mitigate interest-rate risk, particularly in volatile rate markets, as short-term and long-term bonds often presents negative correlation. Additionally, this approach helps temper reinvestment risk by securing yields for an extended period.
The table below illustrates the potential outcomes of implementing a barbell strategy using a suite of our investment-grade municipal ETFs . This strategy entails equal allocations to short and long muni ETFs, such as the VanEck Short Muni ETF (SMB) and the VanEck Long Muni ETF (MLN) . Despite offering nearly identical duration exposure compared to the broad muni index, the barbell strategy provides an additional yield pickup. Furthermore, the flexibility of the barbell strategy allows for quick adjustments to allocation between long and short exposures in response to changes in market conditions related to interest rates.
| Outcomes of the Barbell Strategy: More Yield, Same Duration | |||||
| DTW | YTW | TEY (32% tax rate) | 5-year Treasury Yield | Yield Pickup vs. Treasury | |
| 50% Short (SMB) & 50% Long (MLN) | 5.47 | 3.55% | 5.22% | 4.24% | 98 bps |
| ICE Broad Municipal Index (MUNI) | 5.40 | 3.47% | 5.10% | 4.24% | 86 bps |
Source: ICE Muni Indices, as of 2/29/2024. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.
Enhancing Portfolio Yield: Leveraging Intermediate Municipal ETF with a Roll-Down Approach
Parallel to the barbell strategy, the roll-down strategy focuses on the intermediate portion of the municipal bond curve, which has recently re-steepened. This reconfiguration presents an opportunity to take on some modest duration risk and gradually shift allocation from money-market investments to VanEck’s Intermediate Muni ETF (ITM) .
ITM specifically focuses on bonds with maturities ranging from 6 to 17 years (highlighted in the shaded region in the chart below). This strategy aims to enhance overall yield by capturing additional roll-down return from the steepest part of the curve, in addition to the current yield. As of the end of January 2024, close to 60% of ITM is allocated in the 10-15 year maturity range, which we consider to be the sweet spot on the curve, as the 10s/15s spread has widened the most compared to other parts of the curve.
Going Where the Yield Is: ITM Focuses on the Belly of the Muni Curve
Muni AAA Yield Curve
Source: Bloomberg BVAL AAA muni curve, as of 2/29/2024.
As investors navigate the uncertainties of the current economic and monetary policy environment, the strategic use of barbell and roll-down strategies in municipal bond portfolios offers a nuanced approach to maximizing potential yield advantages while managing the risks associated with interest rate volatility. These strategies provide a comprehensive framework for investors looking to optimize their portfolios in anticipation of the Federal Reserve's potential policy adjustments and the yield curve's eventual normalization.
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