Intermediate Munis: the Relative Safe Harbor?
with Tom Dalpiaz, Managing Director (April 6, 2015)
One quarter of the year is in the books and where do we stand in the municipal bond market? It has been sort of a mini roller coaster ride with intermediate municipal bond yields falling throughout January, rising from early February through mid-March, and then falling again by the end of the quarter. Ten-year high grade municipal bond yields at the end of March were slightly below the levels of early January. Treasury bond yields in the same maturity range exhibited a similar, although wider, roller coaster pattern than municipals so far this year; Treasury yields by the end of the quarter were much further below their early January levels. As measured by the municipal/treasury yield ratio (now 106%), the entry point of committing funds to the municipal bond market is currently more attractive than at the start of the year. Our conservative estimate of the yield that can be garnered currently in the intermediate investment grade municipal bond markets is 2.60%. This translates to a taxable equivalent yield of 4.59% for investors subject to the top Federal income tax brackets. Those yields are attractive in the current world of seven and ten-year Treasury yields at 1.58% to 1.83% respectively.
What about the direction of interest rates for the rest of the year? The Federal Reserve officially dropped its “patient” forward guidance language in March and has stated that changes to its monetary policy going forward could occur at any meeting, guided by economic data releases. Payroll employment numbers had been reasonably strong for an extended period until the last release in early April came in at levels well below expectations. Other statistics released throughout March showed an economy growing only modestly. A variety of measures show inflation at levels comfortably below the Fed’s target of 2%. Oil prices have remained low, the dollar has been strong, and European economic growth is at very modest levels. In the U.S., broad demographic factors and household formation rates also argue for more contained economic growth and restrained inflation. All these factors suggest that the Fed should not be in a hurry to raise rates. Regardless of when that first rate hike occurs, I suspect that these moderating, broader forces will have the staying power to make additional rate hikes occur in a gradual fashion. On the municipal-specific side of things, bonds tend to get harder to find as we go through the months of May, June, and July given the sizable reinvestment typically hitting the market at that time.
My judgment given all these forces at work is that investors who are waiting for a sizable rate rise and price selloff to occur before committing funds in the municipal market may be disappointed. There is an opportunity cost to waiting. Of course we can’t know exactly when that much anticipated rate rise will occur or if it will occur to the sizable degree many expect. There is always a chance of an upward spasm of some sort in rates when the Fed first changes its Fed Funds rate target but I would see that more as a buying opportunity than as the beginning of multiple rate hikes in quick succession. It’s interesting to note that a reasonable size reaction has occurred already in the form of a yield-curve flattening. In the past two years, the municipal yield curve has flattened and the fulcrum point of the shift has been the eight to ten-year maturity range. This may be yet another reason to consider the intermediate maturity space, a sector of the municipal yield curve that I deem to be a relatively insulated one from the expected rise in rates.
Munis by the Numbers
(Sources: Bloomberg, Barclays Capital)
When does 2.60% = 4.59%? When you are an individual investor subject to the top Federal income tax brackets and you capture a 2.60% yield from tax-exempt municipal bonds.
The 2.60% yield stated above is our conservative estimate of an average yield-to-maturity for a municipal bond portfolio constructed under present market conditions with the following parameters: all investment grade credits, average credit rating A1/A+, all bonds mature within 15 years, average maturity of 6 to 7 years, portfolio duration range 3.7 to 4.7 years.
10-year High grade municipal bond yields as a percentage of 10-year Treasury bond yields: 106% (compared to an average ratio of 98% for the past ten years).
Moving from cash to 5-year municipals: +157 basis points (the yield difference on tax-exempt money market funds and Single A rated tax-exempt municipal bonds with a 5-year maturity).
Moving from 2-year municipals to 10-year municipals: +179 basis points (the yield difference on Single A rated 2-year tax-exempt municipal bonds and Single A rated 10-year tax-exempt municipal bonds).
-0.02% March total return of the Barclays 3-Year Municipal Bond Index (+0.41% YTD, +1.51% for all of 2014)
-0.07% March total return of the Barclays 5-Year Municipal Bond Index (+0.76% YTD, +3.19% for all of 2014)
+0.13% March total return of the Barclays 7-Year Municipal Bond Index (+1.09% YTD, +6.09% for all of 2014)
+0.41% March total return of the Barclays 10-Year Municipal Bond Index (+1.26% YTD, +8.72% for all of 2014)
+0.51% March total return of the Barclays Long Municipal Bond Index (+1.58% YTD, +15.39% for all of 2014)
Thomas P. Dalpiaz has over thirty years of experience in the municipal bond business, with much of that time spent as a portfolio manager for private clients, financial advisors, and institutional investors. He was previously a senior portfolio manager with Advisors Asset Management, Neuberger Berman, Sage Capital Management, and Weiss, Peck & Greer. Prior to becoming a portfolio manager, Mr. Dalpiaz was a municipal credit analyst at Weiss, Peck & Greer, as well as Merrill Lynch and The Bank of New York. Mr. Dalpiaz has had a series of articles published in Forbes and he is the author of “Managing Municipal Bond Portfolios for High Net worth Investors,” a chapter in The Handbook of Municipal Bonds, one of the Fabozzi series of investment books. Mr. Dalpiaz has been quoted in the Wall Street Journal, Barron’s, and in Bloomberg News. He has also been a guest expert on Fox Business News, Bloomberg Television, and NPR’s “On the Money.” Mr. Dalpiaz holds an MBA in Finance and a BA in History, both from Hofstra University. He also holds FINRA Series 7, 24, 63, and 65 licenses.
Granite Springs Asset Management, LLC is a privately held SEC registered investment advisor that specializes in fixed income portfolio management and tactical asset allocation investment strategies for private clients, family offices financial advisers, insurance companies, pension plans, and other institutional investors. The investment philosophy at Granite Springs is based on two principal beliefs; that asset allocation is the most important investment decision and; that disciplined risk management leads to superior returns over time.
Granite Springs Asset Management LLC is a Registered Investment Adviser with the U.S. Securities and Exchange Commission and qualified to do business in various state jurisdictions where required. Nothing in this article shall constitute investment advice. This article is for informational purposes only and the opinions expressed are the author’s own.
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The opinions expressed are those of the Granite Springs Asset Management LLC Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. This material is for educational purposes only. Granite Springs Asset Management LLC is an investment adviser registered with the US Securities and Exchange. Registration does not imply a certain level of skill or training. More information about Granite Springs Asset Management LLC can be found in its Form ADV which is available upon request.