Randall W. Forsyth
The rise in bond yields has been a good news/bad news story. For the U.S. Treasury, the increase has been disquieting and has elicited an extraordinary scheme to double its buying of long-term maturities to boost their prices and suppress their yields.
But it is also "creating attractive opportunities for investors as municipal yields rise to some of the most compelling levels seen in recent years," notes Tom Kozlik, head of public policy and municipal strategy for Hilltop Securities.
Unlike in the Treasury market, muni investors are rewarded with higher yields by extending maturities, from the short term to the medium-to-long range centered around 20 years. Also popular are muni bonds with 5% coupon interest rates that have final maturities of 20 years or more but are callable in 10 years or less, which provide attractive current income and defensive properties in a bearish (higher yield) debt market.
These high-coupon callable bonds trade at premiums above their par value, based on the presumption that the issuer will redeem them at the earliest opportunity. That would be analogous to homeowners who refinance their mortgages when interest rates fall.
Muni investors get higher current income, albeit at a premium bond price. On the other hand, these premium bonds tend to be more defensive in a rising yield environment. That's less relevant to buy-and-hold investors, who prefer receiving higher current income up front and care less about losing the few points of premium when the bonds are called or mature.
"Coupon income will, I believe, contribute most, if not all, total return for the foreseeable future," says James Kochan, former head of fixed-income strategy at Wells Fargo and Merrill Lynch.
Investors don't need to take on a lot of duration or credit risk, according to Duane McAllister and Lyle Fitterer, who head Baird Advisors' municipal team. The tax-free market offers what they call "structural opportunities" in terms of individual securities' unique characteristics, among them high-coupon callable bonds.
For example, they cite a Maine Bond Bank 5% bond due in 2038, with ratings of Aa1 and AA, one notch below the top grades of Moody's Investors and Standard & Poor's, respectively. The issue is callable on Nov. 1, 2028, and is priced at a "yield to worst" (which assumes that early call) of 3.51%, a pickup of 90 basis points over a typical 2028 maturity. (A basis point is a hundredth of a percentage point.)
An early call is the worst case, since the payment of those high coupons ends and investors typically get back the par face value of the bond, for which they paid a premium. However, as McAllister and Fitterer explain, the longer the bond remains outstanding and isn't called, the more of the 5% coupon the bondholders receive, effectively increasing the yield. Whether a bond actually gets called may depend on myriad factors, including whether the cost savings to the issuer is enough to cover the expenses of refinancing the debt.
Lawrence Gillum, chief fixed-income strategist at LPL Financial, also calls current muni valuations compelling, given the high taxable equivalent yields available. To an investor in the 35.8% federal tax bracket (32% plus the 3.8% federal Net Investment Income levy), that Maine Bank bond yield would be equivalent to 5.47% on a taxable bond, or 135 basis points more than the two-year Treasury note.
The "sweet spot" in the muni market for Eric Kazatsky, portfolio manager at MacKay Municipal Managers, is the 17- to 20-year maturity range. For benchmark triple-A issues, those maturities yield 4.08% to 4.4%, according to data from Tradeweb.
That is a substantial pickup from the five- to 10-year range, which yields 2.85% to 3.36%. But extending further than that doesn't add substantial return while adding risk, he points out in an interview. A 20-year maturity provides 93% of the yield of a 30-year bond but with 80% of the duration (a measure of a bond's price sensitivity to yield changes).
The muni market's steeper yield curve contrasts with the slope of the Treasury yield curve. Short-to-intermediate Treasury notes provide nearly as much yield as longer maturities, 90% of the yield of the benchmark 10-year issue and 82% of the 30-year long bond. And the two-year Treasury effectively has already priced in an increase in the Federal Reserve's federal-funds target interest rate. Futures markets don't see such a Fed hike until December, and they may well change their minds again by then. Recall that markets had priced in multiple Fed rate cuts earlier this year.
The attractiveness of the tax-exempt market hasn't gone unnoticed this year, with muni exchange-traded funds attracting over $36.3 billion of inflows from the beginning of the year and $59.2 billion in the latest 12 months through mid-August, bringing their assets to $222.9 billion, according to ETF Action. That has helped to absorb heavy new-issue volume, nearly matching last year's record pace of $580 billion, according to Bond Buyer data, which has helped to fund infrastructure projects.
The lion's share of muni ETFs are index-based, a structure less well suited to the muni market, according to managers of muni portfolios. Unlike 500 large-capitalization U.S. equities, which are huge and trade actively, there are millions of individual municipal bonds, most of which trade rarely, each having its own coupon, maturity, and structure in terms of backing, and redemption features. That makes the muni market less efficient than other debt and equity markets.
McAllister, who co-manages the Baird Core Intermediate Municipal Bond fund (and is thus not a disinterested observer in the active-versus-passive debate), pointed out that his fund returned 1.39% annually in the five years through July 31, a span that included the vicious bond bear market of 2022. The $49 billion Vanguard Tax-Exempt Bond Index ETF returned 0.51% per annum over those five years, significantly less than the Baird fund.
However accessed, the muni market's higher yields look attractive for taxable investors.
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