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As Slope Steepens, Long End Offers Value Amid Risks

Outflows from long-term municipal bond mutual funds have driven rates for longer-term bonds higher this summer, pushing the yield curve to its steepest in more than a year.

That’s created an opportunity for investors to sell taxable munis and buy tax-exempts to pick up yield, according to advisors including JP Morgan Asset Management. Buyers have to consider a bond’s coupon structure and credit rating when wading in long-term waters.

Longer bonds with coupons above 5% will provide protection against widening coupon spreads and from extension risk for paper with lower credit ratings, these experts say.

The opportunity has lured some usually squeamish retail buyers to the space, grabbing coupons above 5%, said Rick Taormina, managing director of the tax aware fixed income group, which covers munis and crossover money, at JPMorgan. And with relative values favoring tax-exempt munis, crossover buyers, who stand to benefit, have piled in recently.

“There’s a tremendous amount of opportunity,” he said. “It’s not only for traditional muni investors.”

The rise in muni yields for long bonds in 2013 has easily outpaced the increase in yields on equivalent Treasuries, Municipal Market Data numbers show. From the start of the year through Tuesday, the 30-year triple-A muni has vaulted 142 basis points to 4.28%. The 30-year Treasury yield over that span has climbed just 68 basis points to 3.73%.

The muni two-year-30-year slope sits at 385 basis points, much higher than its average for 2013, at 288 basis points. The slope runs steeper than at any time since the start of 2012.

What’s the primary cause for the increase? Year-to-date outflows from long-term muni bond funds stand at $16.5 billion, Thomson Reuters numbers show. Through July, there have been 22 consecutive weeks of outflows, dating back to the beginning of March.

The upward swoop of 30-year yields accelerated in June after Federal Reserve Chairman Ben Bernanke discussed tapering its monthly purchases of $85 billion in Treasuries and mortgage-backed securities. They continued to climb about a month later as Detroit filed the largest municipal bankruptcy in history and Moody’s Investors Service downgraded Chicago’s credit rating three notches.

As the hike in 30-year muni yields surpassed the move in equivalent Treasuries, their valuations passed into cheap territory, luring crossover buyers from corporates and other comparable investment options, Taormina said. Crossover investors recently took advantage of being able to sell an A- or triple-B-rated corporate bond with a 4.75% coupon and buy an A-rated muni with a coupon over 5%.

“There are times in this market, as the curve has steepened, it’s a little disjointed, and you can sell taxable munis and buy tax-exempts and pick up yield, which really shouldn’t be the case, but it is,” he said.

Outflows from muni bond funds continue to present the biggest danger to the strategy, as they have kept the upward pressure on yields constant. The change in the purchasing habits of traditional buyers of long bonds will also affect demand for them.

If investors are going to buy long bonds, Taormina said, they need to be very cognizant of the coupons they choose. They should make sure they’re opting for coupons of 5% or higher in the space.

There is little liquidity in long bonds with coupons in the 3% and 4% range, Taormina said. Investors realize they will be priced at substantial discounts several years from now when rates increase; retail investors generally won’t buy bonds with dollar prices in the low-90s.

AllianceBernstein is buying long bonds in a high-income fund but trying to avoid some of the extension risk there, said Michael Brooks, a senior portfolio manager in municipal investments at the firm.

“When you’re buying (long) bonds that are lower-rated and they’re callable, you’ve got to be really careful about extension risk,” he said. “There is a bid out there for these things. But there are still some people who are nervous about that.”

When the yield level approaches the coupon, the duration of that bond will extend, Brooks said. Consequently, the higher the coupon is, the more cushion you have against extension risk.

But when you’re in a lower-rated bond and thus have a higher yield, your cushion against extension risk shrinks. A 30-year high-grade bond with a 4.28% yield and a 5% coupon has 72 basis points of cushion. But a triple-B bond with a 5.46% yield and a 5% coupon has already passed that buffer.

DWS Investments, Deutsche Investment Management Americas Inc., hasn’t been adding to its positions on the long end, but it continues to buy there, said Ashton Goodfield, a managing director and portfolio manager there.

“It doesn’t mean you have to extend the duration,” she said. “If you’re managing a portfolio, you could have a barbell. You could find structures so that the bond is priced to the 10-year call. Or, you can manage the overall duration of the portfolio.”

Citi analysts remain bearish on ultra-long munis for the time being, mostly because of a shortage of buyers, Vikram Rai, a municipal strategist at Citi, wrote in a research report.

Historically, funds, insurance firms, banks and to a lesser extent broker-dealers have been stronger buyers of longer maturity bonds, Rai wrote. But buying patterns for this group of investors have changed considerably over the last few years.

While demand from funds has plummeted, it has waned more moderately from property and casualty insurers and brokers since the financial crisis, Rai wrote. And demand may start to fade from banks, given the recent demands updated Basel rules have made upon them.

In addition, the forward calendar should arrive with more new-money issuance, often at a longer duration, he added. Accordingly, the supply of long paper in weak markets could apply upward pressure to long bonds.

“The curve,” he wrote, “could steepen a bit more over the next month before reaching inflexion point.”

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