Municipal Yields Rising

Bond yields have continued to decline in recent weeks, with the benchmark 10-year Treasury bond hovering near 0.54%. It’s a familiar story: With interest rates at historical lows, investors are once again on the hunt for yield.

Although investors may be tempted to wade into riskier asset classes to potentially generate income, compelling opportunities may be found in longer-dated investment grade municipals ­– many of which are generating yields comparable to those of taxable corporate bonds. This is a rare occurrence and an opportunity that is very attractive for a broad range of investors.

Why are long-duration municipal yields increasing?

Increased supply expectations and limited demand from traditional municipal investors are pushing yields higher to attract new buyers.

Supply has been rising

For much of April, municipal supply remained contained, even as demand from banks and insurance companies increased. During this period, the difference in yield between municipal bonds and U.S. Treasuries narrowed, reflecting investors’ increased appetite for risk.

Recently, however, new issuance has inched upward – particularly on the long end of the municipal yield curve. This has resulted in rising yields and widening municipal spreads, even as credit spreads in many other markets have continued to tighten.

Fund flows weakened

April flows into municipal funds flat-lined – even turning negative on some days amid a steady drumbeat of negative headlines – some bordering on the sensational. Adding to the uncertainty: It was recently suggested that states be allowed to declare bankruptcy – an idea likely to meet political and constitutional obstacles.

The potent combination of rising supply and slackening demand pushed up yields on the long end of the curve. In turn, many investment grade municipal credits with 20- to 30-year maturities are now generating federal income tax-free yields north of 3%, or roughly 5% on a tax-equivalent basis assuming a top federal income tax rate of 40.8%.