What does duration do to a fixed-income muni portfolio?
In an effort to combat rising inflation, the US Federal Reserve (Fed) has undertaken an interest-rate hiking cycle to slow growth. At the time of writing, two hikes have already been put in place — a 25 basis point (bp) increase in March and a 50bp hike in May. Expectations are for a series of five more hikes, two of which are likely to be 50bp again.
This would bring us to a 2.75% Fed Funds rate at the end of the year. The last time we saw a 2.75% Fed Funds rate was in 2005. Then, for example, a muni bond investor was compensated 3.83% on a 10-year bond. Now, an investor would only be compensated 2.77% for a 10-year bond. So, if we compare muni markets, then and now, nominal yields would need to move up about 90-110bps to equal 2005 (Chart 1).
Chart 1: Nominal yields, 2005 vs. 2022 — still a ways to go
Source: Bloomberg, May 2022. Please see Important Information for more detail. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
But, if you factor in inflation, it becomes clear that yields would need to move up even higher to equal the real yields from 2005. To do this, we compare the yield curve now to 2005 and subtract inflation expectations. If we compare the real yields then and now, yields would need to rise between 170 and 190bps in order equal the real yields that investors were compensated in 2005 (Chart 2).
Chart 2: Real yields, 2005 vs. 2022 — something has to give
Source: Bloomberg, May 2022. Please see Important Information for more detail. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
Table 1 uses examples of today’s real yields versus 2005 to illustrate how changes in yields impact the value of theoretical municipal bond investments with different duration profiles. In the current market environment, the longer out on the yield curve you go, the greater your exposure to downside risk (Table 1).
Table 1: Yields rise, value falls
Source: abrdn, May 2022.
Longer-duration securities are naturally more susceptible to increased risk from interest-rate moves. And in the past, longer-duration bonds have typically provided investors with increased yield to compensate for the duration risk. But, as Chart 3 illustrates, it’s important for investors to consider whether or not they are actually compensated for that additional risk. This chart demonstrates the flatness of the yield curve over time, pointing to the fact that, on a relative basis, investors have never been paid less to extend duration to 30 years from five years over this time period.
Chart 3: Investors aren’t being paid to take duration risk - Five-year/30-year spread
Source: Bloomberg BVAL Muni AAA Yield Curve 30T; BVAL Muni AAA Yield Curve 5T
Compared to real yields in 2005, investors would experience materially lower losses invested in the front (i.e., shorter) end of the curve. Here, they’d experience price deterioration of 1%-9%, compared to 25% or more on the longer end.
Managing duration risk with shorter-duration muni bonds
Right now, investors face greater interest-rate risk than they have in recent history. And it’s becoming clear from the slope of the yield curve that investors are getting very little compensation for taking on excess duration risk.
But, to write off all of municipal fixed income in light of interest-rate and duration risk would be to throw the baby out with the proverbial bathwater. In our view, investors may do well to invest in the five-year part of the curve or anything shorter dated. In this space, there are both compelling income opportunities and insulation against more interest-rate moves.
IMPORTANT INFORMATION
Chart 1: Bloomberg Municipal Bond 1 Year (1-2) Total Return Index Unhedged USD, Bloomberg Municipal Bond 3 Year (2-4) Total Return Index Unhedged USD, Bloomberg Municipal Bond 5 Year (4-6) Total Return Index Unhedged USD, Bloomberg Municipal Bond 7 Year (6-8) Total Return Index Unhedged USD, Bloomberg Municipal Bond 10 Year (8-12) TR Index Unhedged USD, Bloomberg Municipal Bond 15 Year (12-17) TR Index Unhedged USD, Bloomberg Municipal Bond 20 Year (17-22) TR Index Unhedged USD, Bloomberg Municipal Long Bond Index (22+) TR Index Unhedged USD. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
Chart 2: United States Annualized Rate Inflation Expectations 12 Months Ahead: Philadelphia Federal Reserve; Bloomberg Municipal Bond 1 Year (1-2) Total Return Index Unhedged USD, Bloomberg Municipal Bond 3 Year (2-4) Total Return Index Unhedged USD, Bloomberg Municipal Bond 5 Year (4-6) Total Return Index Unhedged USD, Bloomberg Municipal Bond 7 Year (6-8) Total Return Index Unhedged USD, Bloomberg Municipal Bond 10 Year (8-12) TR Index Unhedged USD, Bloomberg Municipal Bond 15 Year (12-17) TR Index Unhedged USD, Bloomberg Municipal Bond 20 Year (17-22) TR Index Unhedged USD, Bloomberg Municipal Long Bond Index (22+) TR Index Unhedged USD. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
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