Municipal yield curve steepness was a significant contributor to 2011 municipal bond returns, and it currently remains so. Because recent changes in yields have been fairly consistent across maturities, the intermediate part of the curve (10 to 14 years) — where yield differences of as much as 25 basis points currently exist between each maturity — continues to be a focal point. Thus, investors should consider how best to assess the combined risks associated with credit and maturity.Municipal Market Advisors (MMA) recently noted that YTD returns from bonds with a duration of 10 years and shorter had provided less than 15% of all municipal bond market returns, while those with a duration of 20 years and longer had generated 25%. This seems logical to me given that, in my opinion, the Federal Reserve is likely to continue to hold short-term rates at low levels as long as inflation is contained. Investors must consider that the risk measured by the difference in duration of intermediate versus longer-term bonds exposes them to potential price declines exceeding 50% when rates rise. That risk drops to 29% with intermediates.1 The ability to swiftly adjust strategy when market conditions change is also important.The market has demanded yield. High-yield muni mutual funds and ETFs have continued to see inflows, pushing prices higher. Evidence suggests that muni bond investors are using strategies that encompass a combination of intermediate to long duration and high yield to accomplish their goals in today's market.
1 As of 5/10/12. The difference in interest rate risk, as measured by modified adjusted duration, between intermediate and long (Barclays Capital 10-Year Municipal Index and Barclays Capital 20-Year Municipal Index) is 5.89 versus 9.66 = 64% greater interest rate sensitivity. Modified Adjusted duration calculated by Barclays Capital.
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