Boston - Even though interest rates have leveled off a bit in recent months, we continue to believe that municipal floating-rate notes are offering relatively attractive yields with some protection against volatile equity and fixed-income markets.
Muni floating-rate notes -- an often-overlooked part of the market -- may make sense for investors looking to take advantage of rising short term interest rates and a flattening yield curve. This is the case today because short-term rates have risen significantly since the Fed began its tightening campaign in December 2015. In other words, investors can stay on the short end of the curve (2 years or less) and still get much of the yield offered at the longer end of the curve, but with less duration risk.
What are muni floating-rate notes?
Muni floating-rate notes can offer attractive income and a way to potentially hedge against short-term interest-rate risk.
As short-term rates rise, investors may potentially realize additional tax-advantaged income. While fixed-rate bonds could lose value when short rates rise, floating-rate instruments may help protect against rising rates because their duration is effectively zero.
Like bank loans (also called leveraged loans), muni floating-rate notes have coupons that float, or reset, at periodic intervals. The coupons of muni floating-rate notes are tethered to short-term rates such as the weekly Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index 1 or London Interbank Offered Rate (LIBOR). Both SIFMA and 1-month LIBOR have been moving higher lately (see the figure below), and could continue to rise if the Federal Reserve continues to hike its key short-term rate.
Fed and rates in focus
Muni floating-rate notes typically pay yields that are based on SIFMA or a percentage of LIBOR plus a credit spread. Each coupon floats, or resets, at periodic intervals based on the movement of SIFMA or LIBOR. In that way, they are similar to bank loans.
However, muni floating-rate notes are generally investment-grade securities, while leveraged loans are typically rated below investment grade. It's also important to remember that income from muni floating-rate notes is exempt from federal taxes; income from corporate bank loans or Treasury bonds is federally taxable.
Though the January Fed statement removed explicit references to future rate hikes, floating-rate muni yields have already moved considerably higher from a few years ago when the Fed first started signaling a move away from the zero interest rates after the financial crisis.
The Fed has hiked rates nine times over the last three years, from a starting point near zero. With the Fed apparently in the late stage of its hiking cycle, we believe now is the time to look at floating-rate munis.
Bottom line: Muni floating-rate notes may be a way to earn attractive after-tax income with some protection from rising rates.
1The SIFMA Municipal Swap Index, produced by Municipal Market Data (MMD), is a seven-day high-grade market index comprised of tax-exempt variable rate demand obligations (VRDOs) from MMD's extensive database. It is not possible to invest directly in an index.
Eaton Vance does not provide legal or tax advice. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Individuals should consult their own legal and tax counsel as to matters discussed.
An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Longer-term bonds typically are more sensitive to interest-rate changes than shorter-term bonds. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher-rated investments. Derivative instruments can be used to take both long and short positions, be highly volatile, result in economic leverage (which can magnify losses), and involve risks in addition to the risks of the underlying instrument on which the derivative is based, such as counterparty, correlation and liquidity risk.
© Eaton Vance
© Eaton Vance
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