As municipal bonds in the front end of the curve became more expensive relative to Treasuries last week, Veritable was turning to a variant on the barbell strategy to stay short while still picking up some yield.
Rather than getting yield by buying in the longer-middle to back-end of the curve as investors typically do when using the barbell strategy, Veritable is purchasing bonds maturing from five to seven years for the long end of its barbell, said Fred Bacani, Head of Fixed Income & Trading at the Newtown Square, Pa. firm. Veritable has $4 billion of fixed income securities under management, including $3.5 billion of municipal bonds.
"The shorter part of the yield curve, in the two to four year range, is trading at expensive and unattractive levels given the strength in demand from defensively-positioned investors," Bacani said in an interview. "To avoid that maturity bucket, I am structuring purchases in a barbell approach, meaning buying shorter-end and a little bit longer to average the same 2-4 duration range. Furthermore, I can enhance yield further with call structures that are more available in 5-7 year bonds as opposed to the 2-4 range."
The spreads to Treasuries of Municipal bonds with shorter maturities have been tightening since the beginning of the year to Municipal Market Data’s triple-A scale. On Jan. 2 the two-year municipal bond was trading at 4 basis points below the two-year Treasury note, according to data provided by Municipal Market Data and Treasury.gov. The two-year muni traded at a spread of 20 basis points below the two-year note on Oct. 2.
The three-year muni has also become expensive to the three-year Treasury note since the start of the year. On Jan. 2 the three-year muni was trading at a spread of 20 basis points above the three-year Treasury, and then traded at a spread of 40 basis points below the note on Oct. 2.
Dan Heckman, senior fixed income strategist at U.S. Bank, said in an interview that U.S. Bank is avoiding the one to five year range.
"We're not excited about the yield curve from one to five years yet," he said. "If we saw some increased softening in prices, yields going higher in that area, we would probably employ that [one and five to seven year barbell] strategy. But we don't think [the market] is there yet and think smarter to go better out seven to nine years."
The five year muni was trading 40 basis points below the five year Treasury note on Jan 2, and has since dropped to trading 54 basis points below that note on October 2. The seven year muni was trading 31 basis points below the seven year Treasury on Jan 2, and has also become even more expensive to the note trading 46 basis points below it on Oct. 2.
He said U.S. Bank isn't buying bonds maturing in five years and fewer because if there is any future Federal Fund increase, it is likely to put pressure on yields in the one to five year area.
"Think that strategy might make sense once the Fed starts to increase the fed funds rate, and yields go higher in 1-5 year area," he said. "Then we think it would be strategy we might employ."
Bacani said the short end of the curve has become expensive relative to Treasuries to the point where Veritable is even looking at cross-over investments. He said his group has a dedicated taxable trader and many Veritable clients aren't restricted by a "municipal bond only" mandate, so his team scans both the taxable and tax-exempt investment grade spreads for opportunities on an after-tax basis.
One such opportunity is in Treasury Inflation Protected Securities, or TIPS, which are Treasury bonds that pay a real yield plus inflation compensation based on the consumer price index , he said. "In particular, the on-the-run 5-year TIPS looks attractive, as the real yield recently hit positive levels for the first time since a brief stint last September during the taper tantrum. The rather benign inflation outlook and lower commodity prices have been driving the price weakness in the TIPS sector."
He said that he recently bought the on-the-run five-year TIPS, because shorter maturities will still produce a real yield.
"[With TIPS] you are looking at an attractive 2.1% breakeven inflation rate and a positive real yield," he said. "The breakeven inflation rate is the rate by which investors are indifferent between buying the TIPS on an after-tax basis (subject to the maximum federal rate) or a comparable maturity high grade municipal bond."
The current year-over-year CPI is at 1.7%, just below Bacani's 2.1% breakeven rate, he said.
"I think inflation should run at more normalized levels over the course of four to five years," he said. "If so, the TIPS position will outperform. The TIPS position will outperform if actual inflation increases above the breakeven rate and/or if inflation expectations accelerate above current benign levels."
Heckman said he isn't seeing many investors buy TIPS.
"Right now we don't see a lot of inflation in the system and have a period where the labor slack is still pretty significant," he said. "In other words there is not a lot of wage growth. We think wage growth drives inflation and is what causes those securities to perform well."
Heckman said he thinks it's "a bit early" to get involved with TIPS.
