Bond yields have continued to decline in recent weeks, with the benchmark 10-year Treasury bond hovering near 0.54%. It’s a familiar story: With interest rates at historical lows, investors are once again on the hunt for yield.
Although investors may be tempted to wade into riskier asset classes to potentially generate income, compelling opportunities may be found in longer-dated investment grade municipals – many of which are generating yields comparable to those of taxable corporate bonds. This is a rare occurrence and an opportunity that is very attractive for a broad range of investors.
Why are long-duration municipal yields increasing?
Increased supply expectations and limited demand from traditional municipal investors are pushing yields higher to attract new buyers.
Supply has been rising
For much of April, municipal supply remained contained, even as demand from banks and insurance companies increased. During this period, the difference in yield between municipal bonds and U.S. Treasuries narrowed, reflecting investors’ increased appetite for risk.
Recently, however, new issuance has inched upward – particularly on the long end of the municipal yield curve. This has resulted in rising yields and widening municipal spreads, even as credit spreads in many other markets have continued to tighten.
Fund flows weakened
April flows into municipal funds flat-lined – even turning negative on some days amid a steady drumbeat of negative headlines – some bordering on the sensational. Adding to the uncertainty: It was recently suggested that states be allowed to declare bankruptcy – an idea likely to meet political and constitutional obstacles.
The potent combination of rising supply and slackening demand pushed up yields on the long end of the curve. In turn, many investment grade municipal credits with 20- to 30-year maturities are now generating federal income tax-free yields north of 3%, or roughly 5% on a tax-equivalent basis assuming a top federal income tax rate of 40.8%.
Fed policy anchors a steeper curve
Why are yields on shorter-dated credits not experiencing a similar lift?
The explanation is rooted in the Federal Reserve’s credit facilities, which are aimed at improving fixed income market function. These efforts have targeted shorter-dated issues with maturities ranging from one week to 36 months. Considering that the average maturity for the tax-exempt municipal market is 12 years, the Fed’s credit facilities are disproportionately affecting the front end of the yield curve. Over the last month, the spread between AA 30-year and AA two-year municipal yields has increased by 60 basis points, and now stands at 1.50 percentage points.
What’s the outlook?
Fortunately for investors, we believe conditions driving higher municipal yields will persist in the near term.
The Federal Reserve’s $500 billion Municipal Liquidity Facility (MLF) recently expanded the universe of eligible issuers to include a larger percentage of the municipal market, including many smaller cities and counties that were previously excluded. That is good news for municipal credit. More issuers will have access to short-term funding in order to address emerging budget gaps, if needed.
However, the MLF is not yet operational and the rate charged to borrowers is unknown. The facility has a maximum maturity of 36 months. We expect that many issuers with longer-term borrowing needs will choose not to wait and instead turn to public markets.
This increased supply will require a market concession in the form of higher yields, which could bring high quality, tax-exempt municipal yields within spitting distance of taxable corporate bonds – and that’s before factoring in the advantages of federal income tax-free municipal bonds (which can mean up to 150 basis points of extra yield relative to taxable issues, assuming a top federal income tax rate of 40.8%).
Are my munis safe?
With the coronavirus pandemic straining state and local budgets, many investors have expressed concern about large potential defaults. In fact, municipal defaults and bankruptcies have ticked upward in recent years. Nonetheless, they are still rare from a longer-term perspective.
According to Moody’s, from 1970-2018 the average five-year annual default rate for municipals was 0.015%. Defaults spiked to 0.27% during the 2008-2009 recession. But this is a tiny fraction of the average five-year 6.6% default rate for global corporate bonds since 1970.
This is due in part because of state and local governments’ flexibility to raise revenue and trim expenses. And in the current environment, municipal issuers rated investment grade have the added advantage of direct Federal Reserve policy support.
Interest rate environment, demographics remain favorable
When fears subside and markets begin to normalize, we see a number of secular tailwinds for municipal investors. As the population ages, we believe U.S. demographics will continue to support high quality, tax-efficient, income-producing assets. With interest rates low, yield opportunities scarce and the possibility of federal tax rates rising in the future, we see significant value in long-duration, high quality, federal income tax-exempt municipals.
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David Hammer is an executive vice president in the New York office and head of municipal bond portfolio management.