By James Welch, Portfolio Manager, Principal Global Fixed Income
Against the backdrop of strong economic growth in the United States and a job market and wage growth that are continuing to rise at their fastest clip since 2008, the Federal Reserve (Fed) is well on the path to an interest rate hike in the second half of 2015. Consequently, with inflation running below the Fed's stated target level, combined with a strong U.S. dollar, both Treasury and municipal bond yield curves are expected to continue flattening. So, a question for the municipal bond market is: where do we see "value" along the curve? Broadly speaking, we believe the correct answer is 15 years.
The chart below depicts the yield differential between AAA-rated, two-year tax-exempt muni bonds and 30-year tax-exempt muni bonds. This is essentially a map of the slope of the yield curve over time. That slope has now reached near its narrowest level since the beginning of the global financial crisis: 230 basis points. With investors expecting potential increases in short-term interest rates by the Fed - likely sometime this summer - there is the potential for the curve to continue flattening. Given that the level of rates on municipal securities inside of five years are near historical lows, as rates rise, there is the potential for this part of the yield curve to be weighed down since income may be insufficient to cushion price declines.
With the unrelenting flattening since 2013, longer-dated maturities (i.e., those over 20 years) offer only modest extra carry, but meaningful duration risk, especially if rates were to rise. So with the flatness in this longer portion of the curve, investors are not compensated for taking the additional risk. In this type of environment, we believe the risk-reward trade-off favors our preferred maturity point relative to longer-dated tax-exempt muni bonds.
Long-term muni rates that are lower relative to intermediate rates change the risk dynamics and reduce coupon income as a component of total return. For instance, a 15-year tax-exempt bond currently generates 85% of the available yield of a 30-year security with significantly better total return potential because of better "roll-down" characteristics; the 15-year muni bond is in a steeper portion of the yield curve (roll down is the ability of a bond's price to increase, and its yield to decline, as it rolls down the yield curve towards maturity). Additionally, muni bonds look attractive relative to Treasurys for this longer portion of the curve because the ratio of muni yields to Treasury yields exceeds their long-term average.
An active municipal bond manager can help navigate the pitfalls of yield curve and duration positioning. More importantly, a skilled manager can do so within the context of assessing the credit landscape within the asset class. 2014 marked a year of credit-spread compression across the asset class partly because of reduced issuance. 2015 and beyond are set up for increased individual credit risk vulnerable to heightened bouts of volatility. That said, we believe that it will be a credit pickers market!