Investors unhappy with low yields but not convinced of the merit in buying lower-graded muni credits to retain cash flow might be more attracted to another simple strategy: buy longer paper.
The strategy of stepping out the yield curve can always be applicable in a normal interest rate environment, but the current slope of the curve makes it especially attractive now.
The spread between five-year and 30-year triple-A munis shows the yield curve is at one of its steepest levels of the past decade, according to Municipal Market Data. Its average in 2011 has been 303 basis points, versus a 10-year average of 185 basis points.
This implies an investor can pick up an additional 3.03% of tax-exempt coupon on average when moving from five-year to 30-year paper.
Some might hesitate to buy longer bonds due to interest rate risk. But the investor doesn’t have to stretch much to realize substantial gains in yield.
Looking at triple-A debt, a move from a four-year bond to a five-year gives an additional 22 basis points of yield, according to MMD. From five to six years brings another 36 basis points; from six to seven years delivers another 34 basis points.
Take a step down the credit curve and the effect is magnified. Among single-A paper, a move from a four-year bond to a five-year gives an extra 38 basis points; from five to six years gives another 41 basis points; from six to seven, you get another 41 basis points.
“It just starts ramping up,” said John Dillon, chief muni bond strategist at Morgan Stanley Smith Barney. “Moderate extension on the credit curve, moderate extension on the yield curve. That combination is pretty potent.”
Indeed, an investor purchasing a three-year triple-A rated bond would have received a 0.69% yield last week, whereas a five-year single-A bond offered 2.08%.
That’s a pretty easy move to triple cash flow.
“It’s tough to swallow those 0.5% yields and 1% yields,” said Chris Mier, managing director at Loop Capital Markets. “What’s a person supposed to do? They have to commit some of their portfolio to long-term munis.”
Mier noted The Bond Buyer 20-bond index of 20-year general obligation yields still delivered decent yield at 4.46% last week, despite reaching a seven-month low.
“You can pay 2% inflation and still have a decent coupon flow,” he said.
Some investors wouldn’t like the extra duration for fear of inflation risk. Fair enough — but how much sense does it make to buy an overpriced short-term muni as a solution?
That’s the question Philip Condon, head of muni bond portfolio management at DWS Investments, recently posed at a media conference.
Specifying where he sees danger in the market, Condon pointed to what’s usually considered the healthiest place to be: high-grade investments in the four- to five-year range.
“Triple-A levels there are 1% — not particularly attractive,” Condon said.
He said investors will be disappointed if the best they can do is hold to maturity and earn just 1%, particularly as other safe options are available.
“To say, 'I’m worried about inflation, therefore I’m buying an overpriced muni,’ is not the solution,” Condon said.
George Friedlander, chief municipal strategist at Citi, said the five-year spot is too expensive in part because of buying pressure from separately managed accounts that typically purchase shorter paper.
A study by Cerulli Associates estimated total SMA holdings at $2.6 trillion as of 2010, compared with just $470 billion in 2003. Muni holdings within such accounts doubled from 2007 to mid 2010.
For a buyer concerned that stepping out from three years to six is risky in terms of credit risk, Friedlander advocated buying bonds wrapped by Assured Guaranty.
“They have a substantial portfolio of reserves and there isn’t any scenario I can think of where those reserves are eaten through rapidly,” Friedlander said. “Therefore, if you’re getting extra yield relative to higher-rated paper, there is value there.”
MMD’s insured yield curve shows the average bond wrapped by Assured offers a 2.79% yield for a seven-year bond, versus just 1.20% for a triple-A rated five-year bond or 1.90% for a top-rated seven-year bond.
“That’s not a rational relationship to me,” Friedlander said, noting the 89 basis point spread at the seven-year spot. “No matter what you think of Assured as a viable 20- or 30-year monoline — and I’m not making a judgment on that — there should be some value in the first six to eight years of the curve because of the vast reserves that Assured has.”