Muni Market Update: Total Return Investing in Muni Bonds
Standish believes that investors must be compensated for adding additional risk in the municipal market, and that risk/reward is challenged in the current environment. In order to preserve portfolio value, it is critical to focus on total return: income plus price movement.
Total Return Investing in Muni Bonds
July 2016
Municpal Market Update
Rather than focusing solely on a “reach for yield,” we believe investors
should heavily weigh price stability/appreciation in their investment
decision. In the current low interest rate, tight credit spread and flat
yield curve environment, excess yield is often not commensurate
with price risk.
The municipal bond market has staged an impressive and protracted
rally. The strength has been driven by a macro-economic environment
characterized by muddling economic growth and benign inflation. In
a yield starved world, municipal bonds have been further buttressed
by robust investor demand in the face of anemic new issuance.
Municipal bonds have been considered a safe haven for tax-exempt
income and preservation of principal. Investors have recognized the
relatively attractive yields provided by municipal securities, as well as
the high credit quality and diversification benefits when compared to
riskier and more volatile fixed income assets and equities.
The by-products of this rally have included the lowest interest rates
since at least 1960, a tax-exempt yield curve that is the flattest since
the financial crisis and the richest credit spreads since 2007.
As interest rates declined, many investors have sought bonds with
additional yield to bolster their portfolio’s income production, with
too little consideration of price risk. This reach for yield at record
low rates and credit risk premia may cause investors to import
unanticipated risk into their muni bond portfolios. The benefit of
additional yield from longer maturities and/or lower quality can be
quickly overwhelmed by negative price movement if muni valuations
normalize.
For example, an investor who sells 5% of their $10 million portfolio
maturing in 2 years and buys 10 year bonds, picks up $5,000
(0.0005% or 5 basis points) in income
1
. Portfolio interest rate risk
would increase, as duration would extend ¼ year. The entire $5,000
extra yield would be obliterated by a mere 0.002% or 20 basis points
increase in rates.
Equally, credit risk provides limited cushion in today’s market
environment to mitigate the additional risk. Excess yield of BBB
rated bonds only needs to rise by 0.001% or 10 basis points for the
negative price movement to overwhelm the excess yield.
Conclusion:
Standish believes that investors must be compensated for adding
additional risk in the municipal market, and that risk/reward is
challenged in the current environment. In order to preserve portfolio
value, it is critical to focus on total return: income plus price
movement. In Standish’s view, a relatively high quality credit bias and
moderate maturity risk is favorable.
Page 1
By: Daniel Rabasco, CFA, Chief Investment Officer for Tax Sensitive Fixed Income
1
Source: Standish, Thomson Reuters
Muni-Bond Yield Curve Flattest Since 2008
Source: Standish, Thomson Reuters as of June 30, 2016
-
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
Percentage Points
Difference Between 10-and-2 year Muni AAA Yields
Difference Between 30-and-2 year Muni AAA Yields
Heavy demand for higher-yie
lding securities has pushed
longer term bond prices higher and yields lower
Muni-Bond Credit Spreads Narrowest Post-Financial Crisis
Source: Standish, Thomson Reuters as of June 30, 2016
0.25
0.45
0.65
0.85
1.05
1.25
1.45
1.65
1.85
2.05
2.25
Percentage Points
A-rated GO Spread
BBB-rated GO Spread
A-rated Avg Spread = 0.74%
BBB-rated Av
g
S
p
read = 1.51%
The comments provided herein are a general market overview and do not constitute
investment advice, are not predictive of any future market performance, are not pro
-
vided as a sales or advertising communication, and do not represent an offer to sell or a
solicitation of an offer to buy any security. Similarly, this information is not intended to
provide specific advice, recommendations or projected returns of any particular product
of Standish Mellon Asset Management Company LLC (Standish). These views are current
as of the date of this communication and are subject to rapid change as economic and
market conditions dictate. Though these views may be informed by information from
publicly available sources that we believe to be accurate, we can make no representation
as to the accuracy of such sources nor the completeness of such information. Please
contact Standish for current information about our views of the economy and the mar
-
kets. Portfolio composition is subject to change, and past performance is no indication
of future performance.
BNY Mellon is one of the world’s leading asset management organizations, encompass
-
ing BNY Mellon’s affiliated investment management firms, wealth management services
and global distribution companies. BNY Mellon is the corporate brand for The Bank of
New York Mellon Corporation. Standish is a registered investment adviser and BNY Mel
-
lon subsidiary.
MMU/July2016/7-29-16/BR
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