Declining yields and rising prices on the short end of the municipal yield curve are giving municipal investors pause -- and reason to seek out attractive alternatives outside the tax-exempt market where in some cases they can potentially earn more than 100 basis points in extra yield.
While some managers have remained in the municipal market and found select opportunities on the short end, they say it has been extremely challenging, especially given the recent heavy demand and declining volume, which have both been exacerbated by the 2017 tax reform legislation and the summer reinvestment season.
“We have been backing away from very short munis for most of 2018,” said John Donaldson, director fixed income at Haverford Trust. “The combination of a lack of supply and investor demand for exempt income keeps making those shorter maturities progressively more expensive.”
Municipal traders agree that taxable alternatives have appeared cheaper lately when compared to the short end of the municipal bond yield curve in the first 10 years, which they have described as “rich” and “expensive” in recent months.
Since the second quarter of 2018, yields on one-year tax-exempt securities have decreased from as high as 1.75% on May 1 to as low as 1.48% on Aug. 1, according to Municipal Market Data.
“There is good demand from SMAs for cash management equivalents in the first couple of years visa vi taxable alternatives,” an Atlanta trader said on Monday.
Last week, there was a 102 basis-point spread between two-year Treasuries, which were yielding 2.59%, and two-year municipal bonds at 1.57%, he pointed out.
“It’s a big difference, especially when the percentages are not that attractive on the short end” of the muni curve, the trader said.
One-year triple-A municipals are currently yielding 63.2% of the yield of their Treasury counterparts, while the five year is yielding 73.4%, and the 10-year 86.6% as of Aug. 24, according to MMD.
Meanwhile, the one and 10-year percentages are slightly lower than their recent averages of 64.6% and 84.5% between June 1 and Aug. 23.
Over the last year, the percentages in one, five, and 10 years had been as high as 83.9%, 85.6%, and 93.1%, respectively, between Sept. 5, 2017 and Aug. 23.
To avoid the muni richness, Donaldson has focused his attention on higher-yielding taxable opportunities between one and three years, such as short Treasury issues, floating-rate notes for institutional accounts, and most recently New York City general obligation bonds.
Both Donaldson and the Atlanta trader believe the richness stems largely from the overall lack of paper since the start of 2018, following the 2017 tax reform bill.
“The whole supply of bonds five years and in that normally is created by pre-refundings and advanced refundings has been taken out of the market, especially since any existing pre-res rolled off as they matured,” the trader explained.
Tax-exempt advance refundings were eliminated as part of the tax reform legislation.
At the same time, the inviting benchmark rates on the Intercontinental Exchange London Interbank Offered Rate [LIBOR] and the recent glut of Treasury bills is helping to make the short taxable market “exceptionally attractive” by comparison, he said.
“There are no similar factors at work in the muni market,” Donaldson added.
LIBOR is a benchmark rate that some of the world’s leading banks charge each other for short-term loans, and serves as a means to calculating interest rates on various loans throughout the world.
Participating in the taxable market also works in conjunction with Donaldson’s effort of providing tax efficiency, especially for clients in high-taxed states, since the passage of the tax bill.
Among the attractive options, Donaldson has recently purchased bonds from the $60 million competitive sale on Aug. 8 of taxable New York City general obligation bonds.
The deal contained a 2018 maturity priced to yield 2.45%, and a final 2027 maturity priced to yield 3.67%.
At the time of the pricing, the benchmark, generic triple-A GO scale in 2019 yielded 1.48%, while the 2027 maturity yielded 2.42%, according to MMD.
“The interest is exempt from the high state and city taxes,” Donaldson explained. “Depending on the tax bracket for each client, that exemption from taxes can be very valuable.”
Donaldson has also found bonds with call provisions in the shorter maturity range to be attractive.
“The mix of call protection and final maturity that has worked best for us has been a call in 2021 or 2022 and final maturity between 2026 and 2028,” he said, adding that the preferred pricing has been between 20 and 30 basis points extra yield above the generic, benchmark triple-A curve for the call date, which translates to 30 to 40 basis points to maturity.
Donaldson uses equivalent credit quality and bullet structures for those comparisons, and finds the best solutions for each client based upon the precise tax situation for both federal, and state and local income taxes, as well as liquidity.
“If a client needs a cash reserve, 6-month Treasury issues at a 2.25% yield, which is exempt from state taxes, is attractive and very liquid,” he added.
Meanwhile, to a lesser, but still notable, extent the Atlanta trader said some of the richness is caused by a decrease in retail investor participation following recently increased disclosure through MSRB Rule G-15 made effective in May.
The new version of the rule enhances the transparency of costs associated with municipal securities transactions for retail investors, and requires broker-dealers to disclose the markup or markdown for a transaction -- expressed as a total dollar amount and as a percentage of the prevailing market price.
The new disclosure allows retail investors more insight into how efficiently trades are being executed and quantifies the client’s costs from markups -- the dollar difference between the customer’s price and the security’s prevailing market price.
The trader said the rule highlights the use of markups, which can affect an investor’s overall yield and return in a municipal bond transaction. The increased transparency can also cause retail investors to cease using financial advisors who charge markups or commissions on individual bonds.
“Advisors typically buy 10 years and in for retail, but they are seeing more retail buyers waving the white flag about fees and commissions, and that’s bringing down yields in the first five years of the curve,” the trader explained. “If you are buying bonds in the one to 10-year curve where yields aren’t offering that much, you have to ask yourself how much value are you really adding?”
Tax-exempts have gradually outperformed U.S. Treasuries since mid-2017, particularly on the short end of the yield curve where participants concerned with rising interest rates continue to park cash, analysts Matthew Gastall and Monica Guerra of Morgan Stanley Wealth Management wrote in a monthly municipal report on Aug. 23.
However, Gastall and Guerra suggested that as short-end yields have risen in Treasuries more than in municipals, investors focused on the lowest durations may consider adding high-quality taxable counterparts into their fixed income portfolios. “Maintaining the appropriate asset allocation frameworks continues to be important due to the increasing attractiveness of cash and the continued possibility of fixed-income weakness,” they wrote.
But, not all opportunities are lost in the municipal short end of the curve, especially for managers whose investment approach is limited to that area.
“There’s no question that short muni yields are very close to their taxable equivalent levels, which makes taxable bonds a viable alternative for some investors,” Jonathan Law, a vice president and portfolio manager at Advisors Asset Management, told The Bond Buyer earlier this month.
“While such a move might provide a little more yield in the short run, a long-term investor would be more willing to overlook these tight -- and perhaps transitory -- ratios and remain in tax-exempt securities,” he explained.
Despite facing some seasonal challenges in the last few months, Law said it has been business as usual for him as he employs a traditional municipal bond strategy that primarily invests along the first one-third of the yield curve.
“We are typically more active putting cash to work during the heavier reinvestment period of the summer months and this year was no exception,” Law said.
But while he remained active on the short end, it was challenging given the high demand and lackluster supply. He had to be creative and inventive.
Law said it often required additional credit due-diligence to bring in securities that weren’t originally on an investor’s buy list, or sourcing callable bond structures with durations similar to noncallable bonds for some portfolios.
“All in all, buying on the short end requires a little patience,” Law said, quoting the phrase “the early bird gets the worm.”
