Jason Mertz: Overall muni markets are off to a pretty strong start, returning 2.7% roughly year to date. As the Fed continues to enter into the late stages of their tightening cycle, how should investors think about duration positioning in today’s environment?
Daryl Clements: They should be looking at adding duration, especially in an environment where yields are likely going to be lower 12 months from now. If that’s the case, duration is your friend.
And not only that, but maturity structure, that’s very important. There’s many ways to skin a cat to get to your duration target or your volatility target. And in this environment, the municipal yield curve is kind of wonky, right? It’s kind of U-shaped. So, what you want to try to do is avoid that belly where yields are low. You can buy a combination of 15-year bonds and one-year bonds—that’s your barbell—and have a higher yield than just concentrating in seven- or eight-year bonds. And as the municipal yield curve normalizes over time, that positioning will likely outperform the positioning of a concentrated or a ladder.
JM: One of the highlights of the muni market has been so far is the municipal credit landscape. You look at BBB-rated and high-yield rated indices, they’re up about 4.5%, dramatically outpacing what you see in AAA counterparts. This is an area of the market that we have had a lot of conviction in, and we view as an opportunity for investors. As the economy continues to slow, do we still have that conviction going forward?
DC: Yes, we do. BBB spreads are nearly twice their historical average. Fundamentals are strong, and that’s not an overstatement when you look at state balance sheets and municipality balance sheets that have more cash than they’ve ever had before. So even if the economy does slow, what you’ve seen in the past is that spreads are wide, and credit tends to hold its value in those environments.
JM: Right, and there’s dual benefits to that trade, right? You mentioned the increase in yield due to that credit spread.
DC: That’s right.
JM: And as flows return to the market, we expect that spread to compress, which can bolster your total return profile within strategies.
DC: Absolutely.
JM: Technicals have certainly improved so far in 2023, and we’re in a very, very strong environment right now with the seasonal summer dynamics. In discussing with our equity colleagues, they often tell us that they have bond math envy right now given just the high level of starting yields that fixed-income investors have. What does it take for the muni market to see high single digits, low double-digit returns over the next 12 months?
DC: It doesn’t take a lot. When you look at the index, roughly a 4% yield. Well, what if municipal yields fall by just 50 basis points, a half a percent over the next 12 months. On a six-year duration, that’s a duration of the index. That’s another 3% on top of your 4% yield, so a total return of 7%. What if yields fall 1%, a little bit more aggressively? On a six-year duration, that’s 6% on top of your 4%, now you’re at 10%. There is a lot of opportunity there for investors over the next 12 to 18 months.