The Week in Muniland

Volatility this week in the US Treasury market sent muni yields higher and made the curve steeper. For the week, two-, 10- and 30-year AAA yields rose 1, 3 and 8 basis points (bps), respectively. The Bloomberg Municipal Bond Index (the Index) was down 0.28% last week, bringing year-to-date returns to 0.64%.

• Why it matters: Munis underperformed US Treasuries this week, which was welcomed as munis cheapened relative to US Treasuries. As seen in Display 2, munis cheapened slightly and remain cheap in the 5-to-10-year part of the curve. In our opinion, the best value remains on the longer end of the curve, particularly 15 years and longer. The value on the shorter end of the curve, specifically in the 5-year part of the curve, is not necessarily in munis but rather in US Treasuries. Display 2 shows a –3 bp after-tax spread, which means you are earning 3 bp more to own a US Treasury bond versus a AAA muni bond, whereas investors should be earning at least 22 bps more on the muni bond. This negative spread means munis are expensive. When possible, investors should look at owning US Treasuries in the 5-year part of the curve instead of munis. We are not necessarily recommending selling to make that move, but perhaps invest cash in shorter US Treasuries.

The steepness of the municipal yield curve potentially provides significant upside for active muni bond investors.

• Why it matters: The value found in a steep yield curve comes not only in the form of higher yields, but also in the form of roll (Display 3). Roll is, in essence, profiting through the passage of time due to a steep yield curve. As a bond rolls down the curve, the bond is gaining in value as its yield falls. As the yield curve steepens, the value of roll becomes even more valuable. Yield plus roll is basically the estimated total return of that bond. We recommend investors take advantage of this steep yield curve by investing in longer maturity bonds. However, be mindful that the long end of the yield curve comes with longer durations, so to reign in durations we suggest investors also pair these long bonds with shorter munis and perhaps US Treasuries. This will have the effect of reducing the overall interest-rate risk of the portfolio. For those investors who are okay with tolerating interest-rate volatility, there is no need to invest in shorter bonds. The changing shape of the yield curve is just another reason why investors should be somewhat active in their approach to the market, to take advantage of opportunities such as roll. Sitting like an elephant is generally a losing strategy.

Security selection is somewhat overlooked by investors, but there are corners of the muni bond market where bonds are relatively cheap.

• Why it matters: We believe one area of opportunity is in the prepay energy sector. Prepay energy bonds allow issuers to lock in discounted power rates from an energy provider. The prepay energy market is not mainstream, but it is growing rapidly. Most muni separately managed account managers avoid this sector, but that may change over time as the sector continues to grow. For those innovative investors who are willing to seek out opportunities, there is potential upside. Many prepay obligors are rated in the single-A category, but they have yields that are much higher than the typical single-A issuer. On average a prepay obligor rated single-A has a credit spread to a AAA muni bond of 103 bps, which is 64 bps above a typical single-A rated bond. This structure offers a built-in yield advantage, and spreads could decline as adoption increases. For those investors looking for more information, please read our recent blog, Prepay-Energy Bonds: A Muni Segment Poised for Growth.