Longest Bonds Losing Appeal as 10-Year Yields Rise: Muni Credit

The longest-dated municipal debt, which beat all maturities in the $3.7 trillion market in the past year, is losing its appeal for investors such as AllianceBernstein LP and analysts at Morgan Stanley.

Both companies say debt maturing in five to 10 years offers the best value, even though mutual funds focusing on longer maturities have attracted twice as much cash this year as ones with bonds maturing earlier. Yields on 10-year munis have risen to the highest level since August relative to those on two-year securities as the U.S. economy strengthens.

The 1.5 percentage point yield gap points to a strategy called the roll, in which bonds gain value as they age, the firms say.

“This is a gift,” said Michael Brooks, a portfolio manager in New York at AllianceBernstein, which oversees $31 billion of munis and says its intermediate funds outpaced their peers in the past five years.

The Federal Reserve pegging its benchmark rate near zero “means we’re going to have a steep yield curve for the next three years, and a steep yield curve is going to allow us to capture returns from roll,” Brooks said Feb. 5 at an investor briefing in Manhattan.

Roll Approach

With local yields still close to four-decade lows, the roll strategy is one approach to investing as most analysts predict interest rates are set to rise along with a recovering economy. Yields on 30-year Treasuries will climb to 3.42 percent by the first quarter of 2014, from about 3.17 percent yesterday, according to the median response of 47 analysts in a Bloomberg survey. It would be the highest since April 2012.

AllianceBernstein and Morgan Stanley, owner of the world’s largest brokerage, suggest shunning longer maturities as hiring gains and a rally in the Standard & Poor’s 500 Index brighten investors’ economic outlook.

The reward for extending beyond 10 years has also slimmed. Yields on 30-year benchmark munis are only 1.05 percentage points above those on 10-year obligations, about 15 percent below the one-year average, data compiled by Bloomberg show.

‘Price Risk’

Interest rates on lengthier maturities will increase at a faster pace than on shorter maturities, said Michael Zezas, a muni strategist at Morgan Stanley in New York.

“If you think interest rates are moving higher, then the long end of the curve is subject to more price risk from that type of environment,” he said.

Still, investors have been buying longer munis for their higher relative yields. U.S. mutual funds focusing on munis due in 10 years or longer have added $2.5 billion in 2013, almost double the amount poured into those with securities maturing in five to 10 years, Lipper US Fund Flows data show.

As a result, munis maturing in 22 or more years have earned about 1.1 percent in 2013, beating the 0.6 percent gain for the broader market and all other maturities, Barclays Plc data show.

Brooks and Zezas say the way to achieve gains in 2013 is by buying bonds maturing in about six to 10 years. Those securities will increase in value as they age because of the relatively large yield difference between maturities.

Cushion Check

“You don’t have much of a cushion to protect you against negative returns” should the Fed start raising rates, Brooks said in an interview. “But that cushion has been provided through roll, if you go out and get it.”

Brooks is also focusing on munis rated four to six levels below AAA because his analysis shows those securities posted outsize gains in previous periods when the Fed increased borrowing costs. Ten-year munis rated A+ yield about 0.8 percentage point more than top-rated debt, about double the 10- year average, data compiled by Bloomberg show.

Since 1983, in the five periods in which the central bank raised interest rates, single-A bonds due in five years generated average annualized returns of 3.1 percent, according to Brooks. That beats the 2.2 percent average gain for benchmark munis and a loss of 1.1 percent on Treasuries.

“Not only are you picking up extra yield, you’re getting protection against interest-rate risk,” Brooks said at the briefing.

In trading yesterday, benchmark 10-year muni yields were little changed at about 1.87 percent, near the highest since August, Bloomberg Valuation data show.

Following is a pending sale:

NEW YORK CITY MUNICIPAL WATER FINANCE AUTHORITY plans to sell $435 million of tax-exempt debt as soon as Feb. 19, according to the Office of Management and Budget. The bonds are secured by a second lien on water-system revenue, after the authority’s first-lien debt. Moody’s Investors Service rates the second-lien credit Aa2, third-highest and one level below the first-lien bonds. (Added Feb. 12)

To contact the reporter on this story: Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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