New Trends and Opportunities in the Municipal Markets

Moises Ospina, CIMA®, IMS Consultant
October 18, 2016

Clients often wish to invest money in short-term instruments, and while individual municipal bonds have been historically recognized as intermediate to long-term investments, there have been many recent opportunities in short-term municipal bonds for investors in higher tax brackets.

The Capital Markets Group at 1st Global has been predominantly building portfolios in the corporate taxable market in the last six months. There are some opportunities for clients in high tax brackets in which municipal bonds will deliver superior tax-equivalent yields, but it hasn’t been the case for the vast majority of clients.

In fact, in the last six months, our team didn’t find many opportunities in either municipal or corporate bonds inside the three-year timeframe.

We have structured bond ladders using FDIC CDs in the short portion of the fixed-income portfolio strategies — it doesn’t make much sense to leave the FDIC insurance on the table to get an extra 10 basis points or so in a corporate or municipal bond.

We have seen a trend in the short-term municipal market in the last couple of months and have noticed a rather interesting move in the A-, AA- and AAA-rated papers across general obligation and some revenue bonds.

The short-term municipal bonds with maturities inside two years are currently showing wider spreads than a year ago. This is particularly appealing, given the fact that safer instruments, such as money markets, Treasuries and FDIC-insured CDs, are delivering low yields. As of Oct. 7, 2016, the two-year Treasury note was trading at 0.84 percent, while a two-year newly issued FDIC CD was showing a 1.15-percent coupon for the week of Oct. 3, 2016.

The chart in Figure 1, taken from Bloomberg, shows the behavior of the AAA municipal bond benchmark curve between the Oct. 7, 2015, yield (in white) and the Oct. 7, 2016, yield (in orange). Back in October 2015, the AAA municipal benchmark in the one-year timeframe was at 0.25 percent, while the same benchmark in October 2016 at the one-year level was closer to 0.75 percent.

Our fixed-income team at the Capital Markets Group recently purchased AA general obligation municipal bonds in school districts with yields to maturities ranging from 0.85–1 percent. A client in a 40-percent tax bracket will have a tax equivalent yield ranging from 1.41–2.5 percent — the 30-Treasury bond was trading around 2.46 percent in the same timeframe. The two-year bond also shows how the Treasury yield (in yellow) traded around the same level to the municipal AAA Oct. 7, 2016, benchmark.

The Muni-Treasury Ratio

The muni-Treasury ratio measures how attractive municipal AAA bonds are in relation to the U.S. Treasury paper with similar maturities.

The Bloomberg chart in Figure 1 shows that the 10-year Treasury was at 1.73 percent, while as of Oct. 7, 2016, the AAA municipal benchmark in the same timeframe was around 1.65 percent.

The chart from Bloomberg in Figure 2 shows the 10-year AAA municipal benchmark to the Treasury since 2001. The ratio indicates that the 10-year AAA municipal benchmark was trading at 95 percent to the comparable Treasury. The higher the muni-Treasury ratio, the more attractive municipal bonds are relative to Treasuries.

The average ratio since 2001 was 94.7, with the high for the fourth quarter of 2008 at 190.27 percent and the low at 79.25 percent during the fourth quarter of 2009.

The muni-Treasury ratios on the Bloomberg yield graph reflect that the short-term municipal bonds are currently very attractive — the one-year AAA municipal benchmark is around 125 percent to the comparable Treasury, and the two-year AAA municipal benchmark is currently around 100 percent (meaning that the yields are similar).

We believe that the AA and AAA short-term municipal bonds with strong financial statements could be a viable solution to investors looking to invest in fixed-income instruments inside the two-year timeframe.

Short-Term Municipal Bonds

We have recently seen clients in California within the 50-percent tax bracket investing in AA-rated school districts with positive operating incomes at a 0.9-percent yield to maturity or 1.8-percent tax equivalent yield. Other short-term instruments, such as the one-year Treasury and FDIC-insured CDs, were trading around 0.63 percent and 0.85 percent, respectively.

Another strategy that clients can discuss with advisors relates to maturity swaps. The strategy involves exchanging municipal bonds with longer maturities for shorter ones with similar or higher-rating qualities inside the two-year timeframe.

Clients could take capital gains, which is especially true if municipal bonds were purchased when interest rates were higher, and the clients have been holding the bonds for longer periods of time. The strategy could benefit clients in two ways: either taking a potential taxable gain to offset losses or shortening the overall duration on the fixed-income portfolio. We don’t believe the strategy is suitable for everyone, but it will be worthwhile for the advisors and clients to have the conversation to analyze the potential implications.

The Bloomberg yield graph also reveals that, as of Oct. 7, 2016, the muni-Treasury ratio in the three- to 10-year timeframe wasn’t as attractive that for shorter bonds with municipals trading around 80 percent to the comparable Treasury — the higher demand from retail clients for bonds in the three- to 10-year timeframe has reduced the spreads, and this is reflected in the chart.

The Capital Markets Group and the advisors at 1st Global work closely together to make sure that clients can benefit from suitable opportunities that arise in the markets. Contact your advisor to discuss the strategies further and find out if shorter municipal bonds are a good fit in your overall portfolio.

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