Jason Mertz: Daryl, it feels like Groundhog Day, with yet another challenging quarter for muni investors. The index was down about 4%, bringing year-to-date returns to –1.4% for the year. So what happened in August and September?
Daryl Clements: There’s a couple of things you could point to, the first being the constant drumbeat from the Fed of higher rates for longer. Also, the Fed recently removed two rate cuts next year. And then it's just the expectation of more Treasury issuance.
JM: But the economic landscape has certainly changed.
DC: So, you go back a year. The Fed funds rate was about 2.5%; today it's 5.5%. Inflation was running over 8%; now it’s less than 4% with core inflation, core CPI, at 2.5%. So, the economy is clearly slowing.
JM: The Muni Bond Index is yielding [the] highest it's been since 2007, 4.33%. On a tax-equivalent basis for someone in the highest tax bracket, that's north of 7.25.
DC: Oh, it's clearly an opportunity. Yields are as high as they've been in a generation, basically. If you expect yields to fall over the next 12 months, you want duration, because that will provide a boost to your total return.
And within that, you want to be mindful of your maturity structure. The municipal yield curve has a wonky shape, it's kind of a U shape. So, if you barbell around that, if you buy a 15-year bond and a one-year bond in equal amounts and compare that to the yield of an eight-year bond, you'll have a higher yield, but with the same interest-rate sensitivity.
And then credit. And what I mean by that: single A-rated bonds, BBB, some high-yield bonds, where spreads are wider than their long-term average, even though municipalities and states are in their strongest balance-sheet position ever. So you may want to take advantage of credit if you can.
JM: With income levels the highest they've been in over 15 years, you have a bit of asymmetry at your disposal. What exactly does that look like over the next 12 months?
DC: Yield not only provides income, but it also provides downside mitigation. And when you look at the asymmetry of returns today, it's astounding. For example, 10-year Treasury yield goes up 100 basis points over the next 12 months. The index return will, in essence, be flat. However, if the 10-year Treasury yield were to fall 100 basis points, that same index is up nearly 8.5%.
That is astounding, Jason. But investors aren't recognizing that. They’re still a little shell-shocked. However, I think over time, as investors realize the benefits here—the upside relative to the downside mitigation—reason will prevail.