Treasury Rally Exposes Value In Munis

July 3, 2012

Steven C. Huber, CFA, FSA, fixed income portfolio manager and head of portfolio strategy for Global Multi-Sector Bond, Core, and Core Plus Strategies

The combination of a dramatic rally in the U.S. Treasury market and elevated supply in the municipal bond space has drawn taxable investor interest to the attractive valuations in the municipal market. With Treasury yields reaching record lows in May and June amid concerns relating to Europe and global growth, many AAA rated municipal bonds now offer an absolute yield advantage relative to equivalent-duration U.S. Treasuries. We see value in this market given that AAA rated munis do not add significant credit risk, compared with other spread sectors. Most tax-exempt securities are backed by dedicated revenue streams and/or the full faith and credit of the municipality.

A metric used to assess relative value in the municipal market is the ratio of the yield on AAA rated tax-exempt securities to U.S. Treasuries of comparable maturities. Historically, these ratios have ranged from 70% to 90%, which means investors are typically willing to accept a lower yield from municipals given the federal tax exemption on income from municipal bonds. In contrast to historical norms, these ratios exceeded 115% across much of the yield curve at the end of May, and we believe investment-grade municipal bonds represent value at these levels.

It is against this backdrop that we have opportunistically added to our modest municipal allocation in some of our taxable multi-sector bond strategies. Like any other market, municipal bonds have risks, yet we believe that investment in select general obligation bonds from states with strong management and diverse economies warrant consideration in our portfolios versus equivalent-maturity U.S. Treasuries.

Overall, our fundamental outlook on the municipal market has not changed recently. In the near term, municipal bonds could benefit from several factors. The markets should see continued demand while risk aversion persists, and supply should be limited with municipalities looking to control spending. The market is entering into a seasonal period of light issuance, as well. Moreover, although municipal bonds lagged Treasuries in the recent flight to quality, they have historically outperformed during Treasury sell-offs. Therefore, holding defensive securities like munis can benefit a portfolio should Treasury rates start to rise. We continue to believe that the municipal market is a high-quality sector, and we emphasize the importance of our long-tenured team of municipal credit analysts in the effort to identify and invest in tax-exempt securities appropriate for a diversified fixed income portfolio.