Contrary to conventional wisdom, when interest rates rise, municipal investors who try to limit their risk might be wise to not shorten the maturity on their bonds.
That's the message Guy Davidson, head of U.S. municipals at AllianceBernstein shared with attendees of a recent meeting at the asset manager's New York headquarters entitled: Decoding U.S. Interest Rate Risk, Anticipation of a Fed Reversal.
For those holding bonds with longer maturities, he said, returns will be higher when interest rates make their anticipated ascent and Treasury rates return to historically more normal levels.
Long-term munis are very inexpensive relative to shorter-maturity munis and to comparable Treasury and corporate bonds. Longer-maturity munis have suffered losses since last May, he said, but are at levels today that have already anticipated an ascent in interest rates.
"At this point, as muni investors, you do not win by shortening your maturity, or shortening duration, in the municipal market," Davidson said. "If you think this is unusual, you didn't win last time the Fed tightened, either. The longer your maturity, the better the return, even though the Fed was raising rates."
In the early part of the summer, after muni yields had risen dramatically and credit spreads had widened, portfolio managers advised shortening duration as a defensive measure, limiting exposure to between five and 11 years to buffer against future interest-rate volatility on the long end of the curve.
The market has rebounded somewhat from a summer low reached on Sept. 5, and a period of sustained volatility should replace the selloff for the near term, Davidson said. Interest rates, though, cannot remain at depressed levels indefinitely.
In fact, the Federal Reserve is expected to raise the federal funds rate - defined as the interest rate at which depository institutions lend reserve balances to other depository institutions overnight - around early to mid-2015. A 4% funds rate and a long bond yielding 5.5% to 6% would represent more normal levels for Treasury rates, given an inflation rate of about 2%, Davidson said. The 30-year Treasury yield closed Tuesday at 3.72%.
"As the Treasury market moves to more fair value, so too should the after-tax benefit of municipals move back to a more fair value," Davidson said.
The yield curve steepens when the market starts to anticipate a climb in rates, as it did throughout the summer. If this happens quickly, returns will be affected. But if it takes time to return to normal, he said, investors will get paid more to at least position their investments in a neutral stance.
According to the asset manager's calculations, when rates rise, the bondholder's income, combined with the price appreciation that accompanies the roll of a bond's maturity as time passes, more than offsets the decline in prices.
Given this, if rates were to rise in early 2015, then a 10-year triple-A muni would return 2.48% by the end of 2016. A 30-year, triple-A muni in the same scenario would return 3.49%.
Hovering or falling interest rates would only improve returns, he added. "But what people are struggling with is the move back to normal," Davidson said.
Though there is some logic to the argument, there are other points to consider, said Priscilla Hancock, managing director and municipal strategist at JPMorgan Asset Management. For one, very long bonds, while definitely cheap to treasuries and comparable corporates, don't offer sufficient incremental coupon plus price appreciation to offset a move towards higher rates, she said.
"Even with a base case of no rate movement, our analysis shows that coupon plus price return over a one-year period maxes out in 2030," Hancock wrote. "Beyond that, the coupon only increases marginally and the one-year price return actually diminishes, as the curve is still fairly flat. If rates move upward, the longer-duration bonds will suffer more than their shorter counterparts."