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Is Now the Time to Reach for Yield with Municipals?

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Christopher Harshman, CFA

Director, Portfolio Management (emeritus)

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When it comes to municipal bonds during these turbulent times, strategic thinking has never been more important. 



Municipal bond investors have had a lot to digest over the last couple of years. The stress and strain that the COVID-19 pandemic placed on state and local governments has been significant, matched only by the federal government’s response. Nearly $5 trillion of stimulus and support has been deployed to support the economy, with aid flowing to unemployment benefits, health care, and mass transit. Investors have found comfort in the fiscal support for the muni sector and have flocked to the municipal bond market. According to Lipper, the pace of inflows into municipal bond mutual funds this year has broken records, with $88.5 billion flowing in through the first three quarters of the year.


The increased demand for municipal bonds has driven prices up and yields down. In the current low-interest-rate environment, it’s hardly surprising that the riskier parts of the muni market that tend to yield higher have experienced the greatest demand. Below is a chart of the spread between the Bloomberg High Yield Index yield and the 10-year AAA benchmark muni yield. Looking back to 2008, this difference in yield (or credit spread) has most recently been compressed to a historic low. Note the current spread level versus the average witnessed in the decade between 2010 and 2020. 



 

Spread comparison between high-yield and high-quality municipal bonds

 



Spread comparison between high yield and high quality municipal bonds graph



Sources: Bloomberg, Thomson Reuters, September 2021.


Is sacrificing credit quality the only way to achieve extra yield?


The primary levers that investors have used to achieve higher yield have been trending lower in credit quality or longer in duration. Both translate to higher yields, but also greater risks. Since risk and return are relatively correlated, achieving extra yield means taking on more risk. Importantly, however, there are other strategies that can be employed to achieve more yield.


Purchasing bonds with different structures, such as coupon rates or call dates, can result in a higher-yielding portfolio. Bonds with lower fixed coupons may, at times, see wider price swings in volatile markets compared to higher-coupon bonds, and, as a result, compensate investors with more yield. Many muni bonds have embedded call options that enable issuers (not bondholders) to refinance debt at their discretion. Investors taking on this call risk may earn more yield as compared to an investment in bonds with similar duration or interest-rate sensitivity. In both cases, investors may be subject to extension risk. At a time when investors may question whether credit spreads are adequately compensating for additional credit risk, these other strategies may prove increasingly useful.


Move beyond talk and mitigate risk

What sectors still offer value?

Two sectors in particular—higher education and life care—have lagged others in performance and spread tightening. Higher-education entities are going through significant changes with the advent of virtual learning as well as a reimagining of the collegiate experience that predated COVID-19. Technological changes will keep the sector evolving, necessitating in-depth and experienced credit review and analysis. There will be winners and losers among providers of higher education as the space evolves. That evolution can also be witnessed among life-care providers, also known as continuing care and retirement communities, or CCRCs. As baby boomers retire, this sector will see growth and expansion. Like higher education, life care is a specialized, nuanced sector—especially when compared to the larger hospital and health care universe. Life-care facilities are experiencing changing business models and vibrant competition. Experience analyzing the sector is essential when seeking to identify the potential for investment success. Both higher education and life care are complex, changing sectors that are difficult to analyze, which may explain why spreads have remained wider than those of other sectors. With the right mix of skill and experience, investment opportunities in these sectors are compelling.



The bottom line

Municipal credit quality is currently in a healthy state—revenue collections throughout the pandemic have exceeded expectations, and there’s been significant federal stimulus and support. Indeed, credit quality of the muni market is the strongest it’s been in years. Credit spreads—the additional yield income that accompanies additional credit risk—reflect this strength and are at historic lows. It may be prudent to take some chips off the table, migrate muni exposure higher in credit quality, and wait for a more opportune time to take on additional credit risk. Upcoming legislation being enacted may indeed provide that volatility, in turn driving credit spreads wider. At that point, taking on credit risk may make more sense, if investors are indeed getting more yield.

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