Finding the sweet spot — Value investing along the muni yield curve

Paul Fuchs, CFA, Portfolio Manager, Municipal Bonds | August 27, 2014

  • We look for securities that offer a balance of credit fundamentals and yield.
  • We use a “roll-down” analysis to identify the sweet spot on the yield curve.
  • We believe yield curve positioning is the largest driver of returns for intermediate municipal portfolios.

The cornerstone of the Columbia Management municipal investment process is identifying relative value opportunities. As we construct and manage portfolios, a relative value component is incorporated into every decision. The characteristics and securities of a portfolio are selected because we feel they exhibit an advantageous risk/reward profile. As we evaluate potential investment opportunities, we consider credit fundamentals and the amount of yield or spread. Those securities that offer the best balance of credit fundamentals and yield are selected as acquisition targets. The culmination of purchase and sell decisions results in our municipal portfolios being inherently imbedded with a characteristic of relative value.

In the intermediate space, we feel the largest driver of return is yield curve positioning, followed by credit quality allocation. Our yield curve strategy is formulated by combining our assessment of the slope of the current yield curve with our expectations for curve reshaping going forward. Investing, in part, based on the slope of the yield curve is commonly referred to as “roll-down,” which signifies the aging process of bonds. As bonds age, or become shorter in maturity, they are evaluated at lower interest rates, provided the overall yield environment has not changed and the yield curve is upward sloping. Historically, the municipal yield curve has been upward sloping the vast majority of time. Evaluating a bond at a lower yield will result in a higher price. Roll-down analysis attempts to identify the sweet spot on the curve: the area that offers the most incremental yield for investing an additional year until a bond matures.

In the chart below we look at an illustration of roll-down.

Expected return and percent of maximum expected return one-year horizon — unchanged yield environment

Fuchs

Source: Bloomberg.

The chart above plots the AAA municipal benchmark yield curve as of July 31, the expected total return over the next year for bonds maturing between two and twenty years and the percent of the maximum expected return each maturity currently offers. What we refer to as the “sweet spot” of the yield curve is circled in green. The sweet spot offers intermediate investors the most incremental total return for investing one year farther on the yield curve. Said another way, the sweet spot is the area that offers the vast majority of expected total return without having to invest in longer maturity bonds.

Developing expectations for yield curve reshaping encompasses numerous inputs. Factors such as the current shape of the curve, inflation expectations, the overall health of the economy and Federal Reserve (Fed) monetary policy activities are a few that we consider when developing our view on curve reshaping.

In the intermediate space, we typically consider the investable universe to be between two and twenty years. Within this range, we currently see value in two spots along the yield curve. The first area is the seven to ten year range, as this range captures the vast majority of expected total return available in the intermediate space over the next year. Over the course of a year, investors can capture 92% of the expected total return available between two and twenty years by investing in a bond that matures in seven years. The seven year area represents the sweet spot on the curve — delivering the maximum amount of incremental total return for investing out an additional year until maturity.

The second area in which we see value is in longer-intermediate bonds around twenty years. Our expectation for curve reshaping over the coming years should be conducive to longer-intermediate bonds, as the Fed begins the process of raising short-term interest rates. We anticipate the municipal yield curve will shift higher, but will flatten (bear flattener) with much of the move higher occurring in shorter maturities. The attractive expected total return of longer-intermediate bonds will help offset some of the negative impact of higher rates.

We believe yield curve positioning to be the largest driver of returns for intermediate municipal portfolios. Identifying value along the yield curve — finding the sweet spot — is a key determinant to producing desirable outcomes for investors.

 

Disclosure

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. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.

Income from tax-exempt bonds 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.

Columbia Management and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.

Paul Fuchs

CFA, Portfolio Manager, Municipal Bonds
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