New York - One of the challenges for investors in today's municipal bond market is the level of yields. The Municipal Market Data AAA Scale doesn't offer a 1% handle until 2034. Even though relative value remains attractive, with AAA municipals yielding over 100% of Treasurys all along the yield curve, absolute yields are uninspiring.
Real rate of return
For investors in this environment, we think it could be a good idea to look at real rate of return — the return on an investment net of inflation. Absolute yields may catch the eye, but earnings net of inflation should be what matters. At the end of March 2008, the 10-year Treasury yield was 3.41%, which seems terribly attractive relative to today's yields. At the same time, however, the Personal Consumption Expenditure Deflator (PCE Deflator), which is the Federal Reserve's preferred measure of inflation, stood at 3.20%. That means the real rate of return on 10-year Treasurys was actually 0.21%.
Since 2015, the PCE Deflator has averaged 1.4% — until the economy took a sharp disinflationary turn this year due to COVID-19. At the end of May 2020, the PCE Deflator was 0.5%. With 10-year Treasurys yielding 0.65% at that time, the real rate of return was 0.15%.
Taxable equivalent yield
Municipal bonds yielding more than 0.50% are providing a real rate of return, net of this inflation measure. But that's not the only factor investors can consider. The absolute yield becomes even more enticing when we take into account the tax-exempt nature of muni cash flows.
We think the taxable equivalent yield (TEY) on municipals could be compelling for upper-bracket taxpayers, even at current low rates. Consider, for example, that the TEY on a hypothetical 1% return would be over 2.15% in California, where residents with incomes above $1 million pay 13.3% in state tax and 37% in federal tax. That wouldn't be too bad when Standard & Poor's reports the dividend yield on the riskier S&P 500 Index is now under 1.85%.
Going out the curve
For investors balking at tax-exempt yields below 1%, it might be worth moving out the yield curve. While this may seem counterintuitive at a time of record-low yields, we view municipal bonds as ideally structured for such a move. The vast majority of municipal bonds are issued as premium bonds — that is, priced above par or face value. And most bonds maturing longer than 10 years have embedded calls, which allow the issuers to buy back the debt if interest rates go lower. We can demonstrate that these factors may help to mitigate the risk of going out the curve.
We analyzed the yield pickup available from moving longer by comparing the Bloomberg Barclays Managed Money Municipal Bond (Barclays MM) 7-12 Year Index and the Barclays MM 12-22 Year Index as of June 30. We found that the 12-22 Year Index yielding 1.54% is significantly longer in terms of the maturity1 range, with an average maturity of 16.21 years, versus 9.26 years for the 7-12 Year Index yielding 1.02%. Because of the embedded calls, however, the duration2 of the longer index is 6.15, versus 5.99 for the shorter index. The 12-22 Year Index has 51% more yield with only 3% more duration. We think this is an attractive proposition in the current market environment.
Duration versus extension risk
When municipal yields are below the coupon rate of a callable bond, we assume the bond will be called. The effective duration of the bond will be to the call date. If yields were to rise above the coupon rate, we assume the bond would remain outstanding until maturity, and the duration would be calculated to maturity.
When investors move out the yield curve, they take on extension risk — the risk of having their principal committed for longer than they expected. But in addition to the extra yield for assuming extension risk, investors do get some compensation for being extended. Bonds that will be outstanding longer can provide more cash flow to the investors, which means the yields are higher than if the bonds were called.
Since the risk of extension is tied to the coupon rate, municipal bonds with their premium coupon structure could be especially attractive to investors who are able to take on extension risk. As of June 30, for example, the 12-22 Year Index has an average coupon of 4.46% and a yield of 1.54%, so we calculate that interest rates could rise over 250 basis points and investors would still not be fully extended.
Bottom line: Given the current disinflationary environment, we think there's a compelling case for picking up yield and going long. Thanks to the trade-off that comes with adding yield while taking on extension risk in a portfolio with a premium coupon structure, longing for yield might be a good choice for some investors.
1 Term to maturity is the length of time until a bond must be repaid by the issuer, measured in years.
2 Duration is the sensitivity of a bond's price to changes in interest rates, measured in years.