Maximizing Returns With Long-Dated Municipal Bonds in a Normalizing Yield Curve

For the last two years, the Fed has continued to raise benchmark interest in an attempt to cool the economy, increase borrowing costs, and fight inflation. This has had an interesting effect on the yield curve and short-term bonds.

The yield curve in its simplest form is a plot of current yields of various fixed-income securities of similar credit quality. Normally, the yield curve is upward-sloping. Longer-dated securities will yield more than shorter ones. The idea is that investors want more yield to compensate for the long maturity profile and the unknowns that come with holding bonds 7, 10, or 30 years away from maturing.

But with the Fed raising benchmark rates to levels not seen in decades, the yield curve flipped. T-Bills and other short bonds were yielding more, and with the surge in short-term rates and bonds, longer-dated bonds fell by the wayside.
Today paints a very different picture for the yield curve and bonds.

With the Fed cutting rates and the bond market carnage, the yield curve is starting to correct itself. For example, the 10-year Treasury bond is now yielding around 4.03% — above the 3-year bond at 3.95%. And while very short-dated bonds, such as the 3-month T-bill, are yielding more than longer-dated ones, their yields have dropped significantly over the last year — falling about 75 basis points over the last 52 weeks.

The shift in the yield curve can benefit many longer-dated bonds as investors rush to find income. However, long-dated munis may offer some of the strongest sets of wins for all investors.

For starters, long-dated munis have some of the highest durations out of any bond category. Duration is the measurement of a bond’s interest rate risk that also considers factors like a bond’s maturity, yield, coupon, and call features. Duration can be used to figure out how far a bond will fall when rates rise, and vice-versa. During periods of rising rates, a high duration can kill returns. But during periods of falling rates, it works the opposite way by providing strong returns.

Many municipalities and states issued plenty of muni bonds with long maturities to take advantage of the ZIRP environment of the last decade. With that, the ICE Long AMT-Free Broad National Municipal Index, which tracks long bonds, has a modified duration-to-worst of 13 years. That’s the longest duration for the index in the last ten years and has boosted the index’s sensitivity to interest rates in a big way. ¹

After the abundance of issuance, states and local governments have stopped issuing long bonds. Supplies of these bonds have come to a trickle as many governments don’t want to lock in high interest expenses for decades.

In addition to the potential for duration-propelled price increases and supply constraints, long munis are paying some very juicy yields. The bond type is currently yielding over 4%, putting it ahead of many bond categories, including Treasuries, which have a similar credit profile. What’s truly amazing is that this headline yield only tells part of the story.

Muni bonds are free from Federal and in many cases state taxes. This provides them with a high after-tax equivalent yield. Today, that after-tax yield is as high as 7% for those in the top tax brackets. And with the Tax Cuts and Jobs Act possibly sunsetting, this after-tax yield becomes very good for taxpayers. Right now, long-dated munis’ current after-tax yield makes them a better choice than corporate bonds, Treasuries, and the Bloomberg Aggregate Index for investors in the 24% tax bracket.

All of this sets up a strong total return profile for long-dated munis. Looking at historical data, asset manager Van Eck shows that long-dated munis have been the top performers versus other bonds when the Fed starts to cut and become dovish with its interest rate policies. This chart highlights their findings.

 
Source: Van Eck

With the Fed starting to cut rates and the yield curve returning to normal, long-dated municipal bonds are the clear winners of this policy change. Thanks to their high current yields and interest rate sensitivity, they have the ability to provide a strong total return for portfolios. The best part is there is still time to capture the sector’s potential.

The yield curve hasn’t officially gotten back to normal, as the short end is still top-heavy. But that will and could change when the Fed cuts again. That makes buying long munis a great decision.

The question is how to get that exposure. The muni market remains difficult for investors to tap individually. That means using a fund or expert to get that exposure. And even here, it can be difficult. The number of long-date muni funds has continued to shrink as many have been rolled into other intermediate or broad muni strategy funds.

These funds were selected based on their exposure to the long-dated muni bond universe. They are sorted by their YTD total return, which ranges from 0.7% to 1.9%. They have expenses between 0.09% and 0.28% and assets between $27M and $17.1B. They are currently yielding between 3.3% and 4%.

Overall, changes to the yield curve mean changes to portfolios. And right now, long-dated munis offer the best combination of wins for investors. This includes higher after-tax yields and the potential for duration-induced price gains. For investors looking to make the most out of the changes to the yield curve and the new Fed policy, these bonds can’t be beat.

After the yield curve’s inversion, several fixed income securities are starting to regain their leading positions, especially long-dated municipal bonds. Offering long durations, higher yields and strong credit quality, these bonds could be big winners as the Fed cuts rates further and the yield curve returns to normal.

¹ Van Eck (September  2024).The Case for Long-Term Munis: Positioning for Rate Cuts