October 21st, 2019
Core bonds are a vital component of investment portfolios. These bonds serve as a pillar of strength during risk off periods while other assets may be losing value. Treasuries, agencies and very high-quality corporates fit this category and provide this benefit to investors. We strongly recommend that investors include these bonds in their portfolios, but caution that a set-it-and-forget-it approach can leave money on the table. Often, relative value opportunities arise, and active managers can add value by repositioning into more attractively priced bonds. At United, we constantly search the bond market for relative values; particularly amongst high quality bonds. Today, we feel that we’ve found one in taxable municipals.
2017’s Tax Cuts and Jobs Act made it more difficult for municipal issuers (states, towns, school districts etc.) to refinance debt. The act eliminated issuers’ ability to ‘advance refund’ older, high interest debts with new tax-free bond offerings. As a workaround, municipalities have recently been issuing taxable bonds to refinance older tax-free bonds. As a result, the anticipated supply of taxable bonds has risen dramatically. 30-day visible supply recently hit the highest level since 2010 (per Bloomberg data). We feel the market has not been completely prepared to absorb this unusual amount of supply, and the resulting imbalance has pushed yields higher on a relative basis.
Today, Bloomberg’s 10-year taxable AA yield curve indicates a yield of 2.55%. Since the 10-year US treasury sits at 1.79%, taxable munis offer a greater than usual 76 basis points of spread. Meanwhile, 10-year AA corporates offer 2.4% representing a tighter than usual spread. Considering this, investing in taxable munis offers a rare 15 basis point yield advantage over corporates. This is particularly attractive as AA corporates typically offer higher yield than AA taxable munis.* In our view, taxable munis represent clear value as the uptick in supply has made them particularly cheap relative to corporates. As a result, we have increased exposure to taxable munis in our clients’ IRAs and tax deferred accounts.
*Bloomberg Taxable Municipal AA+ AA AA- 10 year Index BV2TAG10, Bloomberg AA+ AA AA- Corporate Bond 10 Year Index IGUUDC10, spread data since taxable index was created 1/4/16.
Matt DeLorenzo, Fixed Income Strategist