Short-term municipal bonds: Capitalizing on a rising tide
Looking back through our commentaries over the last few years, our focus has generally been on portfolio positioning farther out on the municipal curve, particularly our preference for the long end, relative to the intermediate segment of the curve.
We have generally spent much less time discussing positioning on the short end of the curve. One reason for this is that if you go back several years when the Federal Reserve kept interest rates exceptionally low through quantitative easing efforts, it was much more difficult to get excited about the front end of the yield curve. However, as the Fed has continued to gradually increase rates in recent years, we have started to see a more notable carryover to the short end of the municipal curve, creating a more dynamic set of investment opportunities that warrant investor consideration.
Adapting to the flattening yield curve
Since the Fed’s first rate hike in December 2015, it has raised rates five more times, most recently pushing the Federal Funds Rate to a range of 1.50% and 1.75%. What we’ve observed during this period is a gradual and general flattening of the yield curve, and as the front end of the municipal curve has started to move higher, the opportunity for income and return potential has become more attractive (Figure 1).
Municipal investors have started to take notice. For example, in 2017, Morningstar’s Muni National Short category saw net inflows of approximately $4.3 billion, representing the third highest total across all tax-exempt categories (Figure 2). At the category level, net flows have turned negative thus far in 2018, but this has primarily been driven by one particular fund. Looking below the surface, many short-term municipal strategies have seen positive net flows, and we believe this trend is likely to continue going forward.
Figure 1: Federal Funds Rate and short-term municipal yields since June 2015
Effective Federal Funds Rate (EFFR) vs. yield-to-worst
Sources: New York Fed, Bloomberg, as of 4/30/18. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Short-term muni yields are represented by the Bloomberg Municipal 3 Year Index. Index definitions can be found at the end of this blog post.
Figure 2: Short-term municipal category saw significant inflows in 2017
2017 estimated net flows
Source: Morningstar, as of 4/30/18. Past performance is no guarantee of future results, which will vary.
In addition to the fact that yields have become incrementally more attractive, short-term municipal bond strategies can still provide attractive stability and ballast within an overall municipal portfolio, particularly those with meaningful exposure farther out on the curve. That said, as is typically the case in the municipal market, unique characteristics create an environment conducive to an active approach, even within a relatively defensive short-term context.
Yields change; the market stays the same
When we think about our portfolio positioning in this segment of the market, it’s important to note that many of the traditional municipal benefits we highlight will still apply. For example, short-term municipal bonds are trading at attractive valuations, especially in a tax-equivalent yield context (Figure 3). While pockets of risk remain, municipal fundamentals generally remain strong, further supporting an asset class that has historically had much lower rates of default, versus similarly rated corporate bonds.
Figure 3: Short-term municipal bonds present attractive tax-equivalent yield
Tax equivalent yield for short-term munis versus government/corporate bonds
Source: Bloomberg, as of 5/14/18. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Index definitions can be found at the end of this blog post.
In addition to these key points, we would also note that many of the idiosyncrasies and inefficiencies that often create opportunities in other segments of the municipal market would also apply in a short-term context as well. As is the case with the majority of the municipal strategies we manage, our short-term portfolio applies an active approach, designed to help investors access the market opportunistically and efficiently across fixed- and variable-rate structures.
One example of this theme is the portfolio’s increase in exposure to variable rate demand obligations, or VRDOs. VRDOs are investment-grade securities backed by a letter of credit from an A- or AA-rated bank, which provides liquidity to the holder on a daily or weekly basis upon demand. These securities trade at par and have coupons that reset on a daily or weekly basis (these characteristics have made them an investment staple for money market funds). VRDOs are not to be confused with Auction Rate Securities (ARS), which saw their prices and liquidity drop precipitously during the financial crisis of 2008, as dealers sought to preserve capital and the auction process failed. In recent months, we have seen a meaningful increase in VRDO yields, as coupons have adjusted upwards, moving directionally with short rates, and have moved opportunistically to capitalize on securities currently yielding 1.50%. While our short-term fund isn’t a money market fund, such opportunistic positioning can provide benefits in a short-term context and our portfolio has materially increased exposure to VRDOs. As the Fed continues to raise rates, we believe these securities can provide an attractive buffer going forward, especially when paired alongside longer-term strategies that we manage.
The long end of the municipal curve continues to present attractive opportunities for tax-sensitive investors, but recent trends have helped to create a more compelling opportunity set on the short end of the curve, particularly inside of five years. Although the level of short-term exposure will vary, depending on a particular investor’s risk tolerance, a strong case can be made to be included across a broader set of portfolios. This dynamic has likely contributed to increased flows into the segment. We believe this trend has the potential to continue, and given our active investment nature, we are increasingly excited about the opportunities presented by the short-term municipal market.
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Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Mutual funds are subject to market risk and will fluctuate in value.
A portion of a municipal fund’s income may be subject to state and local taxes or the Alternative Minimum Tax. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities. Such uncertainties could cause increased volatility in the municipal securities market and could negatively impact the Fund’s net asset value and/or the distributions paid by the Fund. Securities purchased by the Fund that are liquid at the time of purchase may subsequently become illiquid, due to events relating to the issuer of the securities, market events, economic conditions, or investor perceptions.
In finance, government and private fixed income securities, such as bonds and notes, are considered investment grade if they have a low risk of default. Investment grade is determined based on a relative scale by credit rating agencies such as Standard & Poor’s and Moody’s. Such credit ratings express the ability and willingness of a borrowing organization to repay its debt and are based on many financial and economic indicators that influence the borrower’s creditworthiness. Securities with a rating of BBB or above from Standard and Poor’s or Baa3 or above from Moody’s are considered investment grade.
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Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated.
Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
Auction rate securities (ARS) are debt or preferred equity securities that have interest rates that are periodically re-set through auctions, typically every 7, 14, 28, or 35 days. ARS are generally structured as bonds with long-term maturities (20 to 30 years) or preferred shares (issued by closed-end funds).
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The Bloomberg Barclays 3-Year Municipal Bond Index is considered representative of the broad market for investment-grade tax-exempt bonds with a maturity range of 2-4 years.
The Bloomberg Barclays US 1-3 Year Govt/Credit Index includes investment-grade corporate debt issues as well as debt issues of U.S. government agencies and the U.S. Treasury, with maturities of one to three years.
The effective federal funds rate is the interest rate banks charge each other for overnight loans to meet their reserve requirements. Also known as the federal funds rate, the effective federal funds rate is set by the Federal Open Market Committee, or FOMC.
Municipal yield curve – Generally, an “AAA” curve is derived from market estimates of yields for bonds with the highest ratings levels in the. municipal market. The base interest rate in the municipal market — that is, the rate against which municipal securities. are most often compared — is the yield on a “AAA” benchmark issue or index.
Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Taxable equivalent yield (also called equivalent taxable interest rate) is the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment. The taxable equivalent yield is commonly used when evaluating municipal bond returns.
A variable rate demand obligation (VRDO) is a municipal security for which the interest rate resets on a periodic basis and holders are able to liquidate their security through a “put” or “tender” feature, at par.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
Yield-to-worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.
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