Boston - The municipal and the Treasury yield curves are different. This is never more evident than when the Treasury curve inverts.
There have been multiple historical incidences of Treasury 2's to 10's inversion in the last quarter century (when 2-year Treasury notes yield more than 10-year Treasury notes). However, since the municipal 2-year AAA benchmark measured by Thomson Reuters Municipal Market Data (MMD) began on Jan, 3, 1995, the municipal curve has never seen a 2's to 10's inversion.
In fact, the municipal curve has been very resistant to inversions of any sort. Going back to 1995, there have been only 40 trading sessions when the 2-year benchmark yield has exceeded the 5-year benchmark (0.45% of the time), and the maximum inversion has been 3 basis points. In comparison, the current inversion between Treasury 2's and 5's has persisted for 89 of this year's 92 sessions, and the maximum Treasury 2's and 5's inversion was 154 basis points in 2010.
We would argue that various factors explain the persistence of a positively-sloped municipal curve. They include investors' preference for maturities inside of 10 years, issuance weighted toward the longer maturities, and the dominance of retail investors who tend toward buy-and-hold rather than continuous repositioning.
Flatter is a challenge
Based on historical precedent, we think it is unlikely that there will be a muni curve inversion, but there has already been a curve flattening. The current MMD benchmark spread, between 2's and 10's, is 38 basis points. This is 1.35 standard deviations flatter than the average spread of 127 basis points since 1995 (standard deviation measures the dispersion of a data set relative to the mean, or average). The current curve presents different challenges than the average historical curve in regards to positioning.
Given that the curve has flattened, we wanted to explore different hypothetical portfolio structures to assess how they might respond, assuming various market scenarios/changes.
Specifically, we constructed three portfolio structures: a 1-10 year equally weighted ladder, a barbell composed of 1-2 and 9-10 year buckets, and a bullet composed of 4, 5, 6 and 7 year buckets (see "Definitions" at bottom of this post).
We created these three hypothetical portfolio structures (ladder, barbell and bullet) using a pool of bonds that met our credit standard (only A- rated and above) and have traded within the last calendar quarter. We chose 1-10 year maturities because this is the range of the Treasury inversion that investors are focused on.
The three hypothetical portfolios were designed to have nearly the same market values and to have similar durations (they range from 4.65 to 4.88 years).
Using the three portfolio structures discussed above, we ran six scenarios: a parallel shift up 50 basis points, a parallel shift down 50 basis points, a bull flattener, a bear flattener, a bull steepener and a bear steepener (see "Definitions" at bottom of this post). We believe these assumptions represent a comprehensive sampling of how yields can move.
Our results are below:
Hypothetical Portfolios as of 3/29/2019
Dur=Duration, Unch=Unchanged, Para Up 50=Parallel Shift Up 50 Basis Points, Para Dwn 50=Parallel Shift Down 50 Basis Points. Source: Eaton Vance, Thomson Reuters Muni Market Data (MMD). Analysis generated using the Perform System. The information presented is based, in part, on hypothetical assumptions. Hypothetical results have many inherent limitations and no representation is made that any account will or is likely to perform in a manner similar to the results shown. Hypothetical results do not reflect the effect of management fees, which if deducted, would reduce the results shown. All data as of 3/29/2019. See "Definitions" at bottom of post for more on scenarios.
In the table above, bolded black numbers denote the best result, while red numbers denote the worst.
The barbell structure produced the best results in the flattening scenario, while the bullet did best in steepening scenario. The equal-weighted ladder structure rarely produced the best performance, but we think it's important to note it was never the worst-performing structure.
Bottom line: The information above may help those muni investors who have both cash to put to work and a definite market outlook, and who are considering different portfolio structures. For investors who are already invested however, we would argue that based on the performance differences in the table above, the costs of restructuring and the potential tax consequences may outweigh the potential gains from making a correct market call. And of course, the market call could also be incorrect.
DEFINITIONS:
Equal weighted ladder: A portfolio with equal weights distributed across a range of maturities by year.
Barbell portfolio: A portfolio that invests in short- and long-duration bonds, while avoiding bonds in the middle durations.
Bullet portfolio: A portfolio of bonds that mature at the same time in order to target a specific part of the yield curve.
Bull flattener: A market in which the yield curve flattens due to longer rates declining faster than short rates. The hypothetical scenario above assumes a 25 basis point decline in 2-year muni yields, and a 75 basis point decline in 10-year muni yields.
Bear flattener: A market in which the curve flattens due to short rates increasing faster than long rates. The hypothetical scenario above assumes a 75 basis point increase in 2-year muni yields, and a 25 basis point increase in 10-year muni yields.
Bull steepener: A market in which the curve steepens due to short rates declining faster than long rates. The hypothetical scenario above assumes a 75 basis point decrease in 2-year muni yields, and a 25 basis point decrease in 10-year muni yields.
Bear steepener: A market in which the curve steepens due to long rates increasing faster than short rates. The hypothetical scenario above assumes a 25 basis point increase in 2-year muni yields, and a 75 basis point increase in 10-year muni yields.
An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.
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