- Return opportunities for municipal bond investors have become a little more challenging amid lower rates and tighter spreads.
- We believe a re-steepening of the yield curve is likely as markets price in stable or faster growth and the likelihood of higher inflation.
- We favor a strategy to benefit from a steeper curve rather than adding interest-rate or credit risk.
The mathematical reality, assuming non-negative interest rates, is that last year’s performance is unlikely to recur. The constraining factor is that the average yield on the Bloomberg Barclays Municipal Bond Index now stands at just 1.50%. A rally of 2019’s magnitude would leave the average yield on the index at just 0.10%, essentially zero.
With price appreciation unlikely to lift returns to the same degree, investors might try to reach for more income by, for example, increasing portfolio duration or reducing credit quality. We think there is a more thoughtful alternative that doesn’t require adding more interest-rate or credit risk.
Pursuing income while protecting assets
We think strategies to benefit from changes in the yield curve offer the most attractive way forward. The municipal bond yield curve is very flat by historical standards. Investors earn little more by investing in a long-maturity bond than they do from a short-maturity bond. This is unusual. In fact, 92% of the time over the past 25 years, the yield curve has been steeper than it is today. Markets have rarely paid investors so little to take more risk. This makes the prospect of searching for income by reaching out farther on the yield curve all the more perilous.
In our view of the data, the current shape of the yield curve is an abnormality. When this abnormality resolves, we believe a re-steepening of the yield curve is likely. We see this taking place in one of two possible ways.
Our base case scenario is that the U.S. economy is stabilizing and a recession is unlikely over the next 12 to 18 months. We also believe that term premiums (the extra yield that investors receive for the added risk of owning longer-term bonds) are too compressed given the strength of the economy. The market is too pessimistic on future growth and inflation outcomes. The resolution of this inconsistency would be a reflating of the term premiums. The consequence would be a re-steepening of the yield curve as the market prices in stable or higher growth and the potential for higher inflation.
In an alternate scenario, economic growth could slow or contract. Under this scenario, we expect the Fed would move to ease monetary policy by reducing short-term interest rates. In the past, such a move has resulted in a steepening of the yield curve.
Benefitting from a steeper curve
In either case — continued growth or economic deterioration — we expect to see a steeper yield curve. In this context, we think we can provide a competitive yield and preserve capital at the same time.
We favor strategies that offer returns from a steepening curve. Our aim is to offset the risk of accelerating growth, inflation, and higher long-term interest rates that are part of our base case scenario. The strategy also offers return potential in the event the economy or inflation surprises to the downside.
Learn more at Putnam.com about tax-exempt income and how we invest.
For additional insights, advisors are welcome to register for our webcast “Utilizing munis in today’s market” (March 12 at 1:15 p.m. Eastern Time) with Portfolio Managers Paul Drury and Garrett Hamilton.
For informational purposes only. Not an investment recommendation.
This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
Putnam Retail Management.