The Week in Muniland

The muni market once again outperformed the US Treasury market as strong demand continued to propel the munis. For the week, two-, 10- and 30-year AAA yields fell 1, 1 and 3 basis points (bps), respectively. The Bloomberg Municipal Bond Index (the Index) returned 0.23% last week, bringing year-to-date returns to 1.86%.

• Why it matters: New issue supply for the holiday-shortened week totaled only $7.9 billion while demand continued to flood the market, with investors adding $1.6 billion, according to Lipper. The muni market so far this year has been the top-performing US fixed-income asset class, with the Index’s 1.86% and Bloomberg Municipal High Yield Index’s 2.21% year-to-date returns outpacing the pre-tax 1.20% return of the Bloomberg US Aggregate and the 0.92% return of the Bloomberg US Corporate High Yield Index. Supply next week is expected to remain light, with ~$10 billion expected to price. Light supply and strong demand should lead to another positive week for munis.
  
  

There is no question that the long end of the municipal yield curve holds almost all the stored value.

• Why it matters: The current rally in the muni market has caused the muni yield curve to stand up. The muni curve is as steep as it’s been in well over a decade. This steepness is being caused by a technical: demand. Demand has been strong this year, with mutual fund and ETF flows approaching $18 billion. However, demand has been somewhat concentrated in the belly and shorter end of the yield curve, which has resulted in a steep yield curve. This uneven demand has resulted in shorter-maturity muni bonds becoming relatively expensive, while longer bonds remain relatively cheap (Display 2). Display 3 will provide a sense of the stored value in longer-maturity bonds. Yield plus roll is basically the total return of a bond. Roll is, in essence, profiting through the passage of time due to a steep yield curve; it’s a freebie. Looking across the yield curve, yield plus roll is 4.5%–5.0% for bonds maturing between 15 and 20 years. Bonds in the five-to-nine-year part of the curve have yield plus roll of only 2.25% to 3.15%. Eventually, the muni curve will flatten toward normal, and when that happens the returns of long bonds will likely be even higher than yield plus roll. In the meantime, investors are being rewarded to wait.
  
  

There is a time and a place for every investment. Now is not the time to be sitting in cash. If you’ve been sitting in cash, you’ve been losing to muni bonds.

• Why it matters: For the past three years, the average after-tax annualized return (assuming the top federal marginal tax bracket) for a three-month T-bill was 2.89%. Over this same time period, shorter-maturity municipals outperformed. For example, the one-, three- and five-year muni indices returned 3.19%, 3.20% and 3.49%, respectively. Today, the after-tax yield on a three-month T-bill is 2.18%. If the fed cuts 50 bps this year, that yield will decline to 1.88%. Today, yield plus roll on a five-year bond is 2.3%, and if yields do fall, a five-year bond will return even more. We believe it’s time for cash investors to step out along the curve. The further investors go out along the curve, the greater the potential return. A barbell maturity structure will allow investors to take advantage of attractive long bonds without just buying long bonds. For example, 20% in the one-year index, 25% in the threeyear index and 55% in the 20-year index would yield 3.34% with a 5.8-year duration. In our opinion, this is a material pickup in yield for a modest increase in duration.