While some may feel like August's "dog days" may already be descriptive of the next few weeks, I sense an undertone of market uneasiness which seems to me to want to push interest rates even higher (see yield curve graph below). A few observations:
Source: BofA Merrill Lynch. As of 7/31/13.
Detroit hovers like a gray mist over the marketplace. I believe market participants have been alerted to an important consequence which, even if it does not come to pass, I think is worthy of attention. As highlighted in his report of August 6, 2013, Michael Zezas of Morgan Stanley warns of how close the municipal bond market is creeping to "extension risk" and its potential impact on portfolios.
"Our analysis suggests 73% of munis carry calls, and 85% of the callable market is trading at a premium, suggesting the market is pricing in the likelihood that most bonds will be called. As rates rise, many of these bonds will "extend" in duration [interest rate risk], making the market more rates sensitive."
Mr. Zezas believes we are at, or approaching, a near-term high for rates, but he goes on to note that in his opinion, if rates do push higher by about 60 basis points, some 20% of premium bonds may turn to a discount, pushing duration significantly longer. I believe the challenge now, is to prepare our portfolios and our clients for this type of event.
1Bond Buyer as of 8/2/2013. Extension Risk Explained: For an option-free (i.e., non-callable) fixed-coupon bond, when interest rates rise, the bond’s duration shortens. That is, the price-yield relationship for an option-free bond is said to be convex, which implies prices decline at a decreasing rate as rates rise (i.e., duration shortens). Thus, while the bond will have likely lost market value with an increase in rates, its future sensitivity to interest rate moves is dampened, which is desirable if you fear continued moves higher in rates. However, if the bond is callable, a different dynamic can apply. Specifically, for a bond trading at a premium to its call price, implying an expectation that the bond will be called, duration can extend as interest rates rise. This happens when the bond’s call option falls out of the money as the new, higher rate regime makes calling and refinancing the bond uneconomical. Consequently, the bond, which may have been trading at a yield that implied that its call date was the time when the bondholder would receive full principal, may now trade to its final, longer maturity as the issuer is less likely to redeem the bond early.
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