- Why invest in long-term muni bonds?
- Why investors should focus on tax-free income and total return
Many investors fled the muni market in 2013, as $60 billion in mutual fund redemptions attests. Particularly hard hit were longer-maturity funds, likely due to investors anticipating higher interest rates and the negative impact that would have on fixed-income investments, especially longer bonds. While such concerns appear rational, is avoiding long bonds in the best interests of investors?
Contrary to popular opinion, we believe that a strong investment case can be made for investing in longer bonds, even in today’s uncertain environment when many are anticipating higher interest rates in the year ahead. Two of the most compelling arguments in support of long bonds are: 1) the current appealing level of tax-exempt income and 2) the total return opportunity they represent for long-term investors.
Come April 15, millions of Americans will be staring at much higher tax bills and we suspect that many taxpayers may be caught off guard by the new higher levels of taxation. The highest federal income tax rate is 43.4%, resulting in many investors taking home barely 56 cents of each dollar earned. Municipal bonds can help investors keep more of what they earn, since the income may be exempt from local, state and/or federal income taxes. As tax rates move higher, investments that provide income exempt from taxes, such as municipal bonds, become more appealing.
There was a significant increase in rates and steepening of the yield curve in 2013, as the yield on the 30-year AAA muni bond increased by 134 basis points, ending the year at 4.19%. While we expect rates to gradually move higher over the next year, we believe that most of the movement — and damage to long bonds — has already occurred. The resulting higher and steeper curve (see Exhibit 1) has left longer bonds with an attractive risk/reward profile.
We believe that muni yields ended the year at compelling levels. For example, a 30-year AAA rated muni bond yielded 4.19%, or 7.40% on a federally taxable-equivalent basis and a single-A rated investment-grade bond yielded 5.00% and 8.83%, respectively. Importantly, investors would have to take on significantly more credit risk to achieve comparable yields from most taxable sectors.
Exhibit 1: AAA municipal yield curve
Source: Thomson Reuters MMD, December 2013.
Our second point is that investors should focus on total return — the combination of income earned plus the change in price. Focusing on one or the other, rather than the total, may be short-sighted. While there may be price pressure on longer bonds, such as in 2013, the high level of income provided by long bonds can help mitigate the loss. In addition, investors with a time horizon longer than two years have typically fared well. Looking over the past 30 years, the trailing two-year total return of municipal bonds (using the Barclays Municipal Bond Index as a proxy for longer muni bonds) was negative only once for a brief two month period. While munis occasionally have had a negative year, they have generally been consistent performers over time.
On a valuation basis, long munis have become more attractive as 30-year yields ended the year at 107% of Treasury yields, meaning a 30-year muni bond is paying 107% of what a 30-year Treasury bond is paying — and this excludes the tax benefit munis can provide. This ratio has been closer to 95% over the longer term. Another way to look at this is that the cheap level of munis potentially represents a cushion against rising Treasury rates if muni/Treasury yield ratios return to historical levels.
Exhibit 2: Barclays Municipal Bond Index calendar year returns
Source: Barclays, December 2013. Past performance does not guarantee future results. It is not possible to invest directly in an index.
Muni mutual fund outflows in 2013 exacerbated the steepening of the curve. Historically, when the yield curve steepens to current levels, demand picks up as retail investors return to the market. The increased demand typically results in a flattening of the yield curve, as investors buy the long-end of the maturity spectrum, enticed by its yield opportunity. In addition, the spread between long and short muni bonds is significantly wider than historical averages, representing a potential opportunity for price appreciation on the long-end when spreads return to more normal levels.
We feel that rates are close to the level at which we will see demand return, providing investors with an attractive total return opportunity.
Exhibit 3: 1-30 year muni bond yield spread
Source: Thomson Reuters MMD, December 2013. Spread represents the difference in yields between the 30-year and one-year muni bonds.
In going against current sentiment, we believe that longer maturity municipal bonds provide an attractive investment opportunity as the tax-exempt yields on long bonds are significantly higher than one year ago and they represent potential capital appreciation if investor demand returns to more normal levels. To conclude, we think investors who fled long muni funds in 2013 may regret doing so as these funds appear poised to outperform with long munis at their current attractive yields and valuations.
There are risks associated with an investment in a municipal bond fund, including credit risk, interest rate risk, prepayment and extension risk, and geographic concentration risk. See the Fund’s prospectus for information on these and other risks associated with the Fund. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.
The Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year.
Income from tax-exempt funds may be subject to state and local taxes and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal and state income tax rules will apply to any capital gain distributions and any gains or losses on sales.