Midyear Muni Strategies in an Improving Market
To us, this seems like a very compelling entry point for munis. Yet many investors remain parked in cash or cash equivalents, waiting to see what happens. Not only have they missed attractive returns compared to US Treasuries (munis have outperformed Treasuries since late 2022), but they’re now giving up significant potential return. Here’s how we think they can take advantage of today’s environment.
Extend your duration target. As we see it, longer duration should be muni investors’ most powerful ally since we expect yields to be lower in 12 to 18 months.
For example, for an investor in the top federal tax bracket of 40.8%, a three-month Treasury bill currently offers an after-tax yield of 3.21%. Compare this to 3.52% for the Bloomberg Municipal Bond Index, which has an average duration of six years as of June 30. If muni yields drop just 50 basis points over the next year, this would add 3.00% in price gains to the 3.52% yield, for a total after-tax return of 6.52%. If three-month Treasury yields decline 50 bps, it would result in just 0.12% in price appreciation, for a total after-tax return of 3.33%.
Consider a barbelled maturity structure. While extending duration today can help capitalize on the interest-rate cycle’s next phase, there’s no all-weather strategy to reach a duration target. A laddered or bulleted approach to maturities works well in certain yield-curve environments. But with today’s inverted yield curve—when short-term yields are higher than those for longer-term bonds—a barbell approach that pairs both short and longer issues may lead to better investment outcomes as the yield curve moves toward a more normal upward slope.
Take advantage of attractive credit spreads. Look to muni credit, such as BBB-rated bonds, for added return potential. The yield premium offered for these bonds relative to AAA-rated munis is nearly twice its historical average. But be selective, not just across issuers but among sectors, too. States remain in excellent financial health as we approach a likely economic slowdown, and while many muni sectors can benefit from states’ strength, not all will.
However, muni issuers in general are resilient and have rarely defaulted, thanks to their inherent power to tax, raise revenues and cut expenses. Since 1970, the 10-year cumulative default rate for investment-grade municipal bonds has been 0.1%, compared to 2.2% for similarly rated corporate bonds.
For now, municipals have the advantage over Treasuries. And given today’s starting yields, we believe munis will likely benefit much more than Treasuries when yields start to fall.
The after-tax yield relationship between US Treasuries and munis can be highly variable. For example, at the start of the year, Treasuries had the advantage over short-term munis, and we took advantage. But by midyear, AAA-rated munis had become more appealing. In fact, based on spreads, they’re now priced within a relatively attractive range. Although shorter munis are becoming expensive again, longer munis remain cheap, especially compared to their five-year averages (Display).