- Aging population and possible tax hikes are positives for municipal bond investing.
- Few state and local governments are launching capital improvement projects, thus limiting the supply of new issues.
Northern Trust experts believe the prospect of higher taxes and an aging population are creating a favorable situation for municipal bond investing. For investors who may not traditionally include municipal bonds in their portfolios, this environment may warrant a closer look.
“A lot of investors are moving into their fixed-income years, and one of the few certainties we’ve see out of Washington this year is higher taxes,” said Timothy McGregor, director of municipal fixed income at Northern Trust. “I like the benefits of the after-tax quality of municipal bonds.”
Yields Rise on Tapering News
Those benefits were reinforced when the Federal Reserve hinted that it would end its third round of bond purchases by mid-2014; the news pushed yields higher, and prices lower, on virtually all fixed-income securities.
In addition, according to Colin Robertson, managing director of fixed income at Northern Trust, if Janet Yellen, the front-runner to succeed Federal Reserve Chairman Ben Bernanke in 2014, gets the job, she is likely to keep the Fed’s policy in place over the next several years.
Additional Factors to Consider
There are other signs pointing in a positive direction for municipal bond investments:
- There is a limited supply of new issues, as few state and local governments are launching capital improvement projects. “We have a decreased supply environment again this year vs. last year,” McGregor said.
- A new group of non-traditional, crossover investors are buying municipal bonds, not for the tax advantages, but because municipals often offer a higher yield relative to corporate bonds. “Municipal bonds look like they might provide a positive total return backdrop,” McGregor added.
A Potential Source of Yield
As of September 2013, the yield curve for municipal bonds was extremely steep — a situation that hasn’t been seen in years past, McGregor said.
“In particular, you’d like to be positioned on the steepest part of the yield curve to benefit from the roll-down — the aging of securities — year to year,” McGregor said. “We currently favor the seven- and 12-year ranges for that reason.”
He added that investors might want to extend their durations to capture additional yield.
“I would encourage investors to go a year or two beyond their normal duration,” he added. “Instead of three years, go five; if five, go to seven. We believe the additional yield available is significant for not much additional risk.” If an investor had moved from 10 to 12 years, he said, the additional interest rate pickup could have been close to 50 basis points.
With the low-interest rate environment expected to last into the foreseeable future, there is a strong argument to be made in favor of municipal bonds for the yield-conscious investor.