Some strategists are advocating a non-traditional approach to managing interest rate risk because of short-term bonds' rising prices, and are telling municipal bond investors to focus on the intermediate and long ends of the curve.
Short-term triple-A munis are currently expensive enough to drive the spread of 5-year AAAs to Treasuries down to the lowest levels in the last two years. The spread plummeted to negative-58 on Jan. 22, and was negative-54 on Wednesday. The spread has not risen above negative-32 since the beginning of 2014. In contrast spreads of 10-year AAAs to treasuries have not fallen below negative-31, and 30-years have remained positive for 2014.
"Fifteen- to 20-year ratio make sense," said Bernard Garruppo, chief executive officer of Granite Springs Asset Management. "If you stay in the 15-year range and rates do start to tick up, you do not have too much duration. You are still protected,"
Investors' flight to short-term bonds started in June 2013 when then-Federal Reserve chairman Ben Bernanke announced that the Fed planned to taper its monthly $85 million bond buying program. This demand for short-term bonds collided with a historically low issuance for the beginning of 2014, creating supply-demand inequality and driving up short-term bond prices. The year-to-date issuance was $33.66 billion as of Feb. 29 , compared with $51.68 billion a year earlier, according to data compiled by The Bond Buyer.
"There is a limited supply, and a lot of cash on the sidelines that investors are putting to work," Garruppo said.
Short-term bonds have long been seen as a haven against interest rates. Their maturities offer investors protection against duration. However, at current prices the cost of the bonds may outweigh the benefits, prompting some advisors to recommend taking advantage of durations at the intermediate and long ends of the curve.
"The real value is at the long end of the curve; it's the only place where one can obtain duration of over 100," said Sean Carney, director of municipal strategy for Blackrock.
Advisors have determined that the main problem is convincing investors to deter from the traditional buy-short strategy to protect against rate increases. While the municipal market in 2014 has not experienced any panic as sweeping as June 2013's taper tantrum, investors are still wary of rate increases.
"In reality, a lot of people say they will extend, but when rates start becoming higher they do not necessary go through with it," said Mikhail Foux, director of credit, derivatives and muni strategy at Citigroup, who also says the short-end of the curve was "overbought."
Already this year current Fed chairman Janet Yellen followed through with the first part of Bernanke's June announcement, implementing cuts to Fed's bond purchases. She began tapering the program by $10 billion a month, decreasing it to $75 billion in January and $65 billion in February.
She did say in a Feb. 19 speech that while tapering was in effect, the Feb had no immediate plans to raise interest rates. Investors remain concerned, because in the past the Fed has said that it intends to raise interest rates when the jobless rate drops below 6.5%, and the jobless rate is currently at 6.6%. Industry experts are forecasting interest rates will increase in mid-to-late 2015.
"The fear is still there that rates are going to go up, and investors are focusing more on a shorter-durations portfolio than a longer one," said Garruppo.
Carney, on the other hand, has seen a variety of institutional, retail and direct investors going into intermediate and long-term funds.
