Bond rally means now is the time to re-evaluate muni holdings

But investors still need to watch out for higher interest rates ahead

Jun 10, 2014 @ 12:01 am

By Guy Davidson

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In early 2013, we urged investors to take a hard look at the interest-rate risk in their bond portfolios. If they didn't do it then, they have a chance to do it now.

The rally in bonds thus far in 2014 is providing investors with another opportunity to reevaluate their muni bond holdings. While interest rates are still considerably higher than they were in early 2013, they're low relative to expected inflation and to the strengthening growth of the U.S. economy. As a result, investors need to be aware of the potential for higher rates ahead.

Last year, we were concerned primarily with reducing interest-rate risk by selling high grade (largely AAA and AA-rated) long-maturity municipal bonds and reinvesting in a combination of intermediate-term, investment-grade municipal bonds and long high-yield municipal bonds. Now we are also worried about the heightened risk in portfolios of strictly short-maturity bonds.

Economists can endlessly debate why long-term interest rates are low and what today's low rates imply about future economic growth and inflation. One thing is certain: the Federal Reserve is on schedule to end its monthly purchases of mortgage and Treasury securities later this year. That will eliminate a very large buyer of bonds from the market. With that drop in demand, rates are likely to go up. Furthermore, the next major agenda item for the Federal Reserve will almost certainly be an increase in short-term interest rates.

Challenges at both ends

Both the short and long ends of the yield curve pose risks to buyers of high-quality bonds today. Short-maturity yields are extremely low: 0.3% on two-year AAA municipals and 0.4% on comparable Treasuries.

With rates this low, the upside return potential is small, and the downside risk is increased. As a result, if short rates rise quicker than expected, investors could experience losses. These may be small, but any loss in this part of the yield curve is extremely rare. As a result, we're advising against portfolios constructed entirely of short bonds. Short bonds can still play a role within a portfolio that targets an intermediate duration, as owning some short bonds can serve to dampen the potential volatility of owning 10- to 15-year bonds, for example.

Long-term yields have fallen dramatically this year: the 30-year Treasury yield is down 50 basis points since the end of last year, while the 30-year AAA-rated municipal yield is down 85 basis points. Lower yields mean lower expected returns for long-maturity bonds, yet the risk remains high. As a result, a portfolio constructed entirely of long bonds in this environment is also a bad idea.

When we compare potential returns from both income and changes in price across maturities, it seems clear that investors aren't sacrificing return by reducing their bond maturity to the intermediate range. And on the plus side, they're lowering their risk from rising interest rates.

High-yield munis for income seekers

For investors who can tolerate more volatility than a traditional high-quality bond portfolio and who want (or need) extra income, adding credit exposure from high-yield bonds to a municipal portfolio is a good idea.

High-yield bonds seem to dance to a different drummer than high-quality bonds. As a result, we have far fewer concerns about the risks related to the long end of the yield curve when dealing with high-yield bonds than we do in the high-quality bond market. While the extra income received for increasing credit risk has declined recently, we still think the value is high relative to the long-term average. And, with limited supply available and competing asset classes priced more expensively, the demand for muni credit is likely to remain strong, supporting prices going forward.

To sum up, we think it's a good time to analyze your bond portfolio based on its potential for risk and return. Short-term bonds can be sold and reinvested in intermediate-term bonds with better return/risk tradeoffs, and the potential returns for long-term high-quality bonds seem too low to compensate for their risk. We think investors would be better served in an intermediate-term portfolio. Finally, municipal credit exposure remains an attractive opportunity, especially for investors who want to reduce their interest-rate risk while maintaining reasonable income.

Guy Davidson is director of municipal investments at AllianceBernstein.

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