Markets & Economy

Total Return Investing in Muni Bonds

Total Return Investing in Muni Bonds

Rather than focusing solely on a “reach for yield,” we believe investors should heavily weigh price stability/appreciation in their investment decision. In the current low interest rate, tight credit spread and at yield curve environment, excess yield is often not commensurate with price risk.

The municipal bond market has staged an impressive and protracted rally. The strength has been driven by a macro-economic environment characterized by muddling economic growth and benign inflation. In a yield starved world, municipal bonds have been further buttressed by robust investor demand in the face of anemic new issuance. Municipal bonds have been considered a safe haven for tax-exempt income and preservation of principal. Investors have recognized the relatively attractive yields provided by municipal securities, as well as the high credit quality and diversification benefits when compared to riskier and more volatile fixed income assets and equities.

The by-products of this rally have included the lowest interest rates since at least 1960, a tax-exempt yield curve that is the attest since the nancial crisis and the richest credit spreads since 2007. 

As interest rates declined, many investors have sought bonds with additional yield to bolster their portfolio’s income production, with too little consideration of price risk. This reach for yield at record low rates and credit risk premia may cause investors to import unanticipated risk into their muni bond portfolios. The benefit of additional yield from longer maturities and/or lower quality can be quickly overwhelmed by negative price movement if muni valuations normalize.

For example, an investor who sells 5% of their $10 million portfolio maturing in 2 years and buys 10 year bonds, picks up $5,000 (0.0005% or 5 basis points) in income1. Portfolio interest rate risk would increase, as duration would extend 1⁄4 year. The entire $5,000 extra yield would be obliterated by a mere 0.002% or 20 basis points increase in rates.

Equally, credit risk provides limited cushion in today’s market environment to mitigate the additional risk. Excess yield of BBB rated bonds only needs to rise by 0.001% or 10 basis points for the negative price movement to overwhelm the excess yield.

Conclusion

Standish believes that investors must be compensated for adding additional risk in the municipal market, and that risk/reward is challenged in the current environment. In order to preserve portfolio value, it is critical to focus on total return: income plus price movement. In Standish’s view, a relatively high quality credit bias and moderate maturity risk is favorable. 

The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any future market performance, are not provided as a sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security. Similarly, this information is not intended to provide specific advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These views are current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed by information from publicly available sources that we believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of such information.

Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. Municipal income may be subject to state and local taxes for out-of-state residents. Some income may be subject to the federal alternative minimum tax for certain investors. Capital gains, if any, are taxable.

BNY Mellon is one of the world’s leading asset management organizations, encompassing BNY Mellon’s af liated investment management rms, wealth management services and global distribution companies. BNY Mellon is the corporate brand for The Bank of New York Mellon Corporation. The Dreyfus Corporation, Standish, a registered investment adviser, and MBSC Securities Corporation are subsidiaries of BNY Mellon.