Where Do We Go From Here?

June 2016

Implications of a "flatter" yield curve

  • 2016 first half performance review
  • Performance measured by credit sector
  • Implications of a "flatter" yield curve
  • Optimal portfolio structure going forward
  • Measuring the performance gain from yield curve roll-down

Much to the chagrin of many fixed income market skeptics, domestic bond prices climbed to even loftier heights during the first half of 2016. Municipal bond yields have fallen to near historic lows. Prior to the extra valuation stimulus from the United Kingdom’s late June Brexit vote, most fixed income markets had already achieved remarkable six-month returns. Through June 27, the Barclays Municipal Bond Index has returned 4.49% year-to-date. Our 2016 forecast for minimal, if any, Fed market intervention looks now to be the most likely scenario, a minority opinion contrary to the one held by the market skeptics. As a result of recent global political events and strong investor demand, we do not foresee any significant forces on the horizon that are likely to disrupt the municipal market. The second half of the year should provide support to current security valuations.

In our April Commentary we discussed various municipal bond market sectors from a credit quality perspective and performance potential. We highlighted the benefits of enterprise debt sectors (e.g., hospital, transportation and utilities). So far this year, revenue-backed debt has outperformed general obligation credit. In addition to analyzing individual credits, we also formulate an opinion on municipal sectors by identifying and purchasing those that we believe have the best prospects to add value to the portfolio. Realizing optimal portfolio performance incorporates a number of factors including sector analysis.

The first chart below illustrates the significant change to the term structure of municipal bond yields which has occurred over the course of this year. While interest rates all along the maturity spectrum registered significant declines, long-maturity (i.e., greater than twenty years) tax-exempt interest rates fell nearly twice as much as short-term rates, creating a much "flatter" curve configuration. Currently, there is only about a 150 basis point yield pick-up by extending from a two-year to a thirty-year maturity bond, well-below the five-year historical average of 284 basis points (see second chart below). Today’s interest rate term structure, in our opinion, argues in favor of portfolio positioning where both average maturity and duration are established to benefit from optimal roll-down effects, generally weighted towards intermediate holdings. Furthermore, the flood of money that has gone into long-term tax-exempt mutual funds has been a significant contributor to the downward pressure on long-term interest rates and could possibly reverse at some point.

A fundamental rule of investment portfolio management maintains that investors must determine adequate compensation (i.e., yield for bonds) for choosing an asset that possesses more inherent risk. Changing risk dynamics, whether real or perceived, are reflected in real time by the constant adjustment of security prices and interest rates in the marketplace. Last week’s decision by the United Kingdom to exit the European Union caused an immediate re-calibration of risk in the financial markets; bonds (less risk) are more valuable, while stocks (more risk) did cheapen considerably on the announcement before recovering. The release of future employment, economic and inflation data will reveal whether the financial markets’ initial “predictions” were prescient.

Our long-held opinion of the fixed income markets remains firmly entrenched. We believe bonds will remain the asset class of choice for investors. This view is further supported by the flow of investment funds out of stock funds and into fixed income funds – particularly municipal funds. The trend is likely to continue and might even pressure interest rates even lower from current levels. However, our measures of risk for extension further out the yield curve for the purpose of capturing a high rate of income lead us to the conclusion that the potential extra reward is not commensurate with the added risk. We remain resolute in advocating for an intermediate return structure in most cases.

Moreover, as overall market yields have declined, so too has the credit spread (additional yield) between higher-rated and lower-rated bond credits. While high yield (non-investment grade) bonds have generally performed in line or better than investment grade bonds, we urge caution at today’s low interest rate levels, and we think credit spreads could possibly start to widen if the economy begins to weaken.

SMC’s recommendation of an intermediate portfolio structure is supported by the added portfolio return that could be achieved by optimal yield curve positioning. The following chart provides an estimate of the actual return in basis points that can be had by simply owning municipal bonds that “roll-down” the curve with the passage of time. Based on our analysis, and given the current yield curve configuration, we believe that owning bonds with maturities or first call dates between six and eleven years provide the best opportunity to add return. The municipal curve peaks at eleven years; a bond bearing this maturity of first call generates 91 basis points of roll-down performance when time to maturity shortens from eleven to ten years.

There are decreasing levels of yield compensation further out on the maturity spectrum. The longest maturities (beyond 23 years) provide minimal roll-down compensation since the additional yield pick-up for each year of maturity extension is negligible.

Provided the municipal yield curve does not undergo a major reconfiguration, we believe investors have the best opportunity for optimizing investment performance by portfolio positioning in the highlighted range. While it is possible interest rates could move lower over the second half of the year, our base case scenario calls for yields to remain near their current levels and performance should primarily be generated from the semi-annual coupon income received and yield curve roll-down


The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management ("SMC FIM"), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.

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