Thus far in 2018, municipal bonds with maturities five years and shorter have materially outperformed their taxable counterparts. As the Federal Reserve has raised the overnight policy rate, short maturity Treasury yields have marched higher. Meanwhile, in the municipal market yields have not moved much at all, and for the shortest bonds (less than 1-year to maturity) yields have even declined. This has led to a significant divergence in the yield offered by short maturity municipal bonds and short maturity taxable bonds such as corporates.
See the below chart for the YTD change in the 2-year AAA municipal yield divided by the 2-year Treasury yield. This ratio is one way to assess the relative value of tax-free municipals compared to taxable bonds. At 61%, 2-year munis are trading at some of the richest levels on record.
The largest drivers of the trend have been very negative net supply (more bonds maturing than being issued) in the municipal market, coupled with a preference by municipal investors to stay short as they anticipate higher rates, and as the finally solid flows into the market we’ve seen so far this year continue to drive demand.
In our Blend Strategy, we entered the year with an overweight allocation to municipal bonds. As short maturity munis have outperformed over the last 7 months, we recently made a shift and sold exposure to short municipal bonds in favor of short corporate bonds. We have executed this trade over the last 2 weeks, reducing our overweight to tax-exempt municipal bonds from 8% to 3%. We received very strong execution on the sale side of the transaction as the dynamics that have led to municipal outperformance in this part of the curve remain intact. The flexibility of the Blend Strategy in moving between investment grade market segments as relative value shifts over time is highlighted by a trade like this. As always, we will continue to monitor these changes and will be prepared to take advantage of such opportunities as they arise.
Sources: JPM & Bloomberg