By Douglas J. Peebles, Chief Investment Officer and Head of Fixed Income, and Michael Brooks, Senior Portfolio Manager, Municipal Bonds, both at Alliance Bernstein
Despite the uncertain impact of recent difficult economic conditions on tax collections, we see significant opportunity to add value in the US municipal bond market. Below, my colleague Michael Brooks reviews where we see the best rewards for risk.
Most state and local governments have made progress in addressing their budget shortfalls in recent months, but there are wide differences in how states and municipal governments are handling their financial difficulties. This makes credit research critical in separating the wheat from the chaff.
In general, it makes sense in the current environment to underweight state and local general-obligation bonds and overweight revenue bonds, such as those issued by public power, water/sewer and transportation authorities, which are backed by fees for essential services such as electricity and water are resistant to budget troubles. However financially pressed, people continue to pay their water bill. History has shown that the revenues earned by these issuers are less dependent on the pace of economic growth than on the property, sales or income taxes that back general-obligation bonds.
The steepest municipal yield curve in recent memory (see chart below) also presents opportunities to add value. Positions in long bonds are likely to outperform as the yield curve reverts to a more normal shape.
The steep yield curve also makes positions in intermediate-term bonds likely to add substantial return through “roll,” which is the tendency of a bond’s value to increase over time as it moves down the yield curve to a lower yield.
Today, for example, the value of a seven-year AAA bond held for a year would increase by 1.7% due to roll alone, even if market yields were unchanged. That’s more than double the 0.8% long-term average return from roll for a seven-year bond held for a year with market yields unchanged.
The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.