Finding value while minimizing volatility can often be a difficult balance in the municipal market, but one analyst said he is finding opportunity in the intermediate part of the yield curve — where the risk is modest and the rewards are the greatest, compared to the short and long ends of the curve.
Not only does Jim Colby, chief municipal strategist and portfolio manager at Van Eck Global, favor the value in the intermediate slope of the curve, but he also views the municipal market overall as a safe alternative at a time of shifting investor sentiment.
Colby said the value in the intermediate range stems from higher rates as measured by the triple-A yield curve between five and 15 years since February, as well as attractive municipal-to-Treasury ratios for 15-year paper, currently hovering at around 131.5%. Yields on 15-year paper, meanwhile, widened to 2.37% as of July 11 from 2.21% on Feb. 1, according to Municipal Market Data.
“Despite the strength of the municipal market overall, these [factors] reflect the inherent value of intermediates,” Colby told The Bond Buyer. “Despite low nominal yields, we compare very favorably,” he said, noting that ratios in general have been north of 100% in recent months.
Colby especially favors bonds maturing in 10 to 14 years because they seem “very attractive” against the backdrop of higher issuance this year, compared to last year.
Much of that has manifested itself in the intermediate range and has come to market with 5% coupons, including June, which saw $40.7 billion issued.
“You don’t have the full blown interest-rate risk that you have with long bonds,” he said. “You are clearly gaining a yield advantage over money market funds or the short part of the curve” where sub-1% yields are available.
Overall, Colby believes the intermediate part of the curve delivers value to investors whose sentiment has shifted to risk-averse from risk-tolerant, creating “a new paradigm” in the face of recent volatility in the equity market, the overseas crisis, and the Federal Reserve Board’s promise of low rates for at least two more years.
“Returns on investments are going to be challenged — not just because rates are low, but because there is a very uneven, uncertain economy,” he said. “The tax-equivalent returns of municipals are very compelling” and offer low volatility, he added.
Meanwhile, recent flows into fixed income may be an indication that “it is currently the preferred asset class over equities,” he wrote in a recent weekly Van Eck blog. “More specifically, I believe municipal bonds have generally offered investors some sense of stability” and security during otherwise turbulent times.
Cash inflows into tax-exempt mutual bond funds in particular have recently demonstrated the strong demand for municipals amid outflows of more than double that amount from equity funds, Colby said.
According to the Investment Company Institute, for the year to date, municipal bond funds took in $26.8 billion through June.
“The money is going somewhere — not all back into municipal fixed income, but we are still producing returns to rival other asset classes,” he said.
The sentiment shift toward stability continues to be visible in investors’ behavior as they attempt to glean value and avoid risk in the current market, he said.
“Since 2009, the financial world has been turned inside out,” and as a result, many investors are still trying to regain a footing in the investment world, Colby said.
That includes identifying appropriate strategies and planning for future market and credit-related obstacles, he said.
“The daunting challenge in markets like this is, how does someone execute a strategy?” Colby said. “Selling bonds and moving from one part of the curve to another is not always a smooth transition. No investor should jump with both feet into this market without fair warning about what issues lay ahead of it.”
“At some point, rates will rise and investors need to have a strategy for the next two years,” he warned. The intermediate slope of the curve can fit the bill for many skittish investors.
“Whatever the uncertainty is you feel about investing long, you are protected in a meaningful way” in the intermediate slope of the curve,” Colby said. “You’re still going to earn some income and at least have a chance to protect your principle if, for whatever reason, rates rise.”
Looking ahead at the municipal market in general, there are few obstacles that could interfere with the municipal market achieving performance to mirror the fourth quarter of 2011, Colby said.
“We do have the [presidential] election in November and all the rhetoric that portends the election — health care and fiscal challenges — but we have not identified specifically an effort to put municipals under the gun with respect to the taxation,” Colby said.
“The big picture concern all of us have is whether or not legislators are going to understand the fundamental municipal market,” he said. “We can’t ignore the possibility of the back side of the election of 2012.”