The 12–22 Year Index is significantly longer in terms of the maturity range, with an average maturity of 16.21 years versus 9.26 years for the 7–12 Year Index and yields of 1.54% versus 1.02%. However, because of the embedded calls, the duration of the longer index is 6.15 versus 5.99. 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.
How is it that investors can add so much yield without taking on more credit risk or duration? The answer is simple: They’re substituting extension risk for duration. Extension risk is the risk of investors having their principal committed for longer than expected. 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, the assumption shifts to the bonds remaining outstanding until maturity, and the duration is calculated to maturity.
The table also shows the duration to maturity, which is the maximum duration that the portfolios would have if all bonds were priced to maturity. In addition to the extra yield for assuming extension risk, investors do get some compensation for being extended. Because the bonds will be outstanding longer, they’ll provide more cash flow to the investor, which means yields are higher than they would be if the bonds were called.
Since the risk of extension is tied to the coupon rate, municipal bonds could be an ideal investment for investors seeking to take on extension risk. The premium coupon structure that dominates issuance offers investors significant protection. For example, the 12–22 Year Index has an average coupon of 4.46% and a yield of 1.54%. Rates could rise over 250 basis points and investors would still not be fully extended.
Given the current disinflationary environment, we think there’s a compelling case for picking up yield and going long. We like the trade-off that comes with adding yield while taking on extension risk in a portfolio with a premium coupon structure. For some investors, longing for yield might be the perfect answer.
The Bloomberg Barclays Managed Money Municipal Bond Index (7–12 years) is an unmanaged custom benchmark that measures intermediate-range bond securities issued by state and local municipalities whose interest is exempt from federal income tax and the federal alternative minimum tax. The index is composed of high-quality municipal bonds (only rated AA- or higher) with maturity ranges between seven and 12 years and excludes calls shorter than five years. The Bloomberg Barclays Managed Money Municipal Bond Index (12–22 years) is an unmanaged custom benchmark that measures longer-term bond securities issued by state and local municipalities whose interest is exempt from federal income tax and the federal alternative minimum tax. The index is composed of high-quality municipal bonds (only rated AA- or higher) with maturity ranges between 12 and 22 years. “Bloomberg” is a trademark and service mark of Bloomberg Finance L.P. (“Bloomberg”). “Barclays” is a trademark and service mark of Barclays Bank Plc, used under license. Bloomberg Finance LP and its affiliates (collectively, “Bloomberg”) or Bloomberg’s licensors own all proprietary rights in the “Bloomberg Barclays Indexes.” Neither Bloomberg nor Barclays Bank Plc or its affiliates (collectively, "Barclays") guarantees the timeliness, accuracy, or completeness of any data or information related to the Bloomberg Barclays Indexes. This strategy is not sponsored or endorsed by Bloomberg or Barclays and each makes no representations regarding the content of this material.