INSIGHTS

On August 03, 2016

Two Investor Virtues For This Low Rate Municipal Environment

We believe it’s a safe assumption that virtually every active municipal bond investor has at one point (or many) in the past six months asked the following two questions:

1) “How much longer will we be in this low rate environment?”

2) “That bond is yielding what? Are you kidding me?”

Question two isn’t exactly a question, but in all fairness it accurately describes the mindset of the investor who is frustrated and stymied by a municipal market that continually produces record-low yields and record-low spreads. For states and municipalities issuing debt, this lower-for-longer environment has been an absolute “gift horse” scenario (especially for weaker issuers) allowing them to refinance their debts and ultimately improve their credit profiles. However, for investors in search of traditional tax-exempt income and capital preservation, patience and flexibility may be two virtues they will need to regularly exercise in order to finish out the year and perhaps beyond.

With half of 2016 officially in the books, the 10-year AAA-rated benchmark bond posted a record-low yield of 1.35% with the 30-year not too far ahead at 2.02% as of June 30. Stirred by the seemingly perpetual flight to Treasuries, the long end of the yield curve has rallied 80 basis points since the beginning of the year while the continuing trend of a flattening yield curve compensates investors even less for allocating cash into long-maturing debt. Despite serious credit issues surrounding a few select states, cities, and commonwealths, heavy demand coming from all fronts of the investment world have tightened credit spreads of both new issue and secondary offerings to levels not seen since the third wave of Fed quantitative easing back in late 2012. According to the MMD (Thompson Reuters Municipal Market Data) benchmark scale, the 10-year BBB-rated bond is yielding an extra 78 basis points over an AAA-rated bond with the same maturity. In comparison, spreads between triple-A and triple-B securities have averaged approximately 100 basis points over the last two years. With portfolios taking on additional duration risk as well as credit risk to meet yield and income targets, municipal investors should make sure their strategies are consistent with their investment objectives and/or tolerances now more than ever.

Reviewing the events that occurred have triggered lower rates during the first two quarters: from the China selloff in January to the immediate fallout of the Brexit in June, investors now should consider and evaluate what type of upcoming catalysts have the potential to impact the direction of fixed income markets during the second half of 2016. In our opinion, there are still too many domestic and global factors that support this lower rate environment. Until the Fed has enough ammunition to justify a path of normalization, municipal investors will be locked in a safe haven asset class and capturing lower overall yields but on the flip side, potentially higher returns on their portfolios. Perhaps the longer we stay in these risk-off conditions, the less likely we’ll be shocked when “that bond is yielding ___.”    

CRN: 2016-0802-5489 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price the trust paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.