The second and third quarter of 2013 became a surprisingly difficult market for US municipal bonds after the increase in last year’s treasury yields. The 10-year treasury rate jumped from 1.60% in early May to 3.00% by September. Even though many municipal issues experienced losses of 10-15% during this period, municipal bond prices started a rebound as early as the fourth quarter of 2013. As 2014 began, US treasuries had the best one-month return since Standard and Poor’s (S&P) downgraded their AAA rating in the summer of 2011. This performance, a low number of new issues, and reduced activity in secondary issues from retail holders ended up keeping investors interested in buying tax-free securities.
As we look forward, the headwinds for municipal bonds in 2014 will come from some of the same headline risks we saw in 2013. The city of Detroit bankruptcy and the declining prices of Puerto Rico debt had a negative effect on most municipal paper. Included in the potential headwinds, some analysts are forecasting higher interest rates for 2014. Consequently, a few ways investors can maximize their yield with municipal bonds is to take advantage of the existing yield curve. Shorter term interest rates (3 years and under) remain low when compared to longer maturities. Most of these municipal bonds under 3 years have a yield to maturity below 1.00%. By extending the investment horizon out to 10 years, an investor can expect yields over 2.50% and over 4.00% when extending out to 20 years. An investor can leverage these various rates by incorporating a bond ladder of blended maturities. The result can diversify a portfolio and shorten the overall average maturity. Another strategy municipal bond investors can employ, is buying premium priced callable issues. Typically, these bonds will have a yield to call higher than a non-callable bond yield with the same term. An additional benefit to premium bonds is they decline less in price relative to bonds with current market coupons.
Interest from investors in municipal bonds will likely continue for the rest of 2014 as state and local governments show a modest pace of improving fundamentals. Investors are left with limited options for income producing investments which are federal and state tax free. Overall, for the right client, municipals continue to look attractive as part of a diversified portfolio.
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