MARKETVIEW
HowMuniLaddersMayHelpInvestorsWhenRatesRise
March6,2017
1836Views
Tax-freeincomeandthepotentialtorealizehigherincomeasinterestratesrise
areamongthepotentialbenefitsofamanagedladderofmunicipalbonds.
Chart1.HowaManagedLadderCouldAdjusttoRisingRates
Projectedyieldsandannualincomebasedonhypotheticalladdersofgeneralobligation‘AA’
ratedmunicipalsecurities
Source:LordAbbettandBloomberg.BondyielddatabasedontheBloombergGeneralObligation‘AA’-RatedMunicipal
Bondyieldcurve,asof February28,2017.
Thechartspresenteddonotrepresenttheresultsthatanyparticularinvestoractuallyattained.Theinf ormation
presentedisbased,inpart,onhypotheticalassumptionsusinghistoricaldataandisf orillustrativepurposesonlyand
doesnotref lecttheperf ormanceof anyspecif icportf oliomanagedbyLordAbbettoranyparticularinvestment.The
hypotheticalresultshavemanyinherentlimitationsandnorepresentationismadethatanyaccountwillorislikelyto
prof itsimilartothoseshowninthechart.Actualperf ormanceresultsmaydif f ersubstantially.Changesinthescenario
assumptionsmayhaveamaterialimpactonthehypotheticalresultspresented.
Allreturnsandyieldsaregrossof f eesandtaxes.Bondsareassumedtobeheldtomaturity.Asbondsmature,
additionalbondsarepurchasedonthef urthestrungof theladderusingthoseproceeds.Itisassumedthatbondsare
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purchasedatparwherethecouponequalstheyield."Income"ref erstocouponincome.
Pastperformanceisnoguaranteeoffutureresults.
InpreviousMarketViews,wespotlightedthechallengingenvironmentformunicipalbondsin
thelastquarterof2016.Inthef inalf ewmonthsof lastyear,munisf acedthreeprimary
headwinds:decreaseddemand,increasedsupply,andanotablemovehigherinmarketyields.The
startofthenewyearbroughtbettertidingsforthemunimarket,asinvestmentf lowsinto
muni-bondmutualf undsreenteredpositiveterritoryaf terastreakof nineconsecutiveweeksof
outf lowstotaling$25billion,accordingtoCitiResearch.FromJanuary11,2016,throughtheweek
endedMarch1,f lowswereapproximately$3.5billion,accordingtoLipperdata.
Intermsof perf ormance,thebroadmunimarket(asmeasuredbytheBloombergBarclays
MunicipalBondIndex)hasreturned1.36%yeartodatethroughtheendof February.That’sa
goodstartcomingof f areturnof -3.62%f orthef ourthquarterof 2016andamodestgainof
0.25%f orthef ullyear.
Althoughconditionshavestabilizedasof earlyMarch,investorsarestillconcernedabouthow
municipalbondsmightf areif theU.S.FederalReserve(Fed)raisesratesin2017,asmany
expect.Onecouldarguethatasf avorableeconomicdataandsignsof higherinf lationcontinueto
emergealongsidesuggestivelanguagef romvariousFedof f icials,thecaseforaratehikein
Marchhasstrengthened(thenextFedmeetingisMarch14–15).Onthedataf ront,theU.S.Core
PersonalConsumptionExpendituresIndex(PCE),theFed’spref erredmeasureof inf lation,
recorded,inJanuary2017,itsbiggestmonthlyincreaseinf iveyears.Astrengtheninglabormarket
providesadditionalimpetusf orahike,asU.S.employmentgrewby227,000inJanuary(latest
dataavailable).
Andasf orwhattheFedsays,arecentrunof hawkishcommentaryf romcentralbankof f icialswas
cappedbyaspeechf romFedchairwomanJanetYellenonMarch3,inwhichshesaidthatthat
shouldemploymentandinf lationdata“evolveinlinewithourexpectations…af urtheradjustment
of thef ederalf undsratewouldlikelybeappropriate."Themarketisalreadybracingf oraFed
tightening,inevidencethatf edf undsf utureshave(asof March3)assigneda96%probabilityof a
ratehikeinMarch,accordingtoBloomberg.
So,thebigquestionf oraninvestormaywellbe:HowcanIbetterpositionmyportf olioto
withstandthepotentialimpactof higherratesinthef uture?We’vediscussedmanyoptions,f rom
short-term,low-durationcredittoinstrumentswithnegativecorrelationtoTreasurybonds,such
asbankloansandhigh-yieldcorporatebonds.Here,wehighlightanotheroption:themanaged
municipalbondladder.(SeeChart1.)
Wearenotmakingthecasethatindividualmunicipalbondsbythemselvesareawaytocounter
risingrates,althoughonecouldarguethathigherrateswouldmostlikelybeaccompaniedbyan
improvingeconomy,anetpositivef ormunicipalissuers.Whatwewouldliketopointoutisthatthe
structureof aladderedportf olioof municipalbondsisdesignedtobenef itf romhigherf uture
interestratesovertime.
Thef undamentalideaof aladderisthattheinvestordeterminesaspecif icbond-maturityrange,
suchastheone-to10-yearperiodsdepictedinChart1.Theinvestorthenbuysabondateach
maturitywithinthatrange,outto10years.Theintentistoholdeachbondtomaturity.Af terayear
passes,the“rungs”of theladderwillhaveshif ted,resultingintheone-yearbondmaturingandthe
10-yearbondbecominganine-yearbond.Astheone-yearbondscomedue,thematuringprincipal
isreinvestedinthelongest-dated“rung”of theladderinordertoreplacetheoriginal10-yearbond.
Thisconstantreinvestmentinthelongest“rung”actstopreservethestructureof theladder.
Whatarethekeybenef itstostructuringaportf olioof municipalbondsinthismanner?First,the
approachprovidesasimple,f airlystraightf orwardwaytoreceivetax-f reeincome.Theinvestor
wouldreceiveeachyeartax-f reecouponinterestf romeachbond,andthencouldchooseto
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spendorreinvestthecashf low.Second,themanagedladderprovides(barringbond-def ault
scenarios)anelementof claritywithrespecttothepriceof thebondstheinvestorwillreceive,
giventhatthebondsareheldtomaturityandwillmatureatparvalue.
Third,themanagedladdercouldpositionaninvestortobenef itf romhigherinterestratesinthe
f uture.Thisbecomesevidentwhenrevisitingtheladderstructurediscussedabove.Returningto
theone-to10-yearladderexample,let’sexploreasimplescenariowhereinyieldsacrossthe
municipalbond-maturityspectrumriseby0.50%overthenext12months.Tobesure,thisrisein
yieldsmayresultinanegativepriceimpactontheexistingbonds,giventhatmunicipalbondsare
notcompletelyinsulatedf romchangesininterestrates.Remember,though,thatinatypicalladder
portf olio,theintentof theinvestoristoholdthebondtomaturity,atwhichpointheorsheexpects
toreceiveparvalue,makinganypriorpricechangeslessrelevant.Further,theinvestornowhas
theproceedsf rommaturingbondstoreinvestatratesthatare50basispointshigher,thus
increasingtheoverallannualincomegeneratedbytheportf olio.
Howmightthatplayoutduringasustainedperiodof risinginterestrates?InChart1,welayouta
scenariowherebyaf terestablishingaone-to10-yearladder,yieldscontinuallyriseby0.50%f or
thenextf iveyears.Eachyear,asearlier“rungs”of theladdermature,theprincipalisreinvested
intolonger“rungs”withpresumablyhigheryields.Theendresultisanincomestreamthatrises
everyyear,withtheportf olio,inf iveyears’time,generatingroughly80%moreincomerelativeto
whatithadoriginallyprovided.(Foravisualdemonstration,tryourinteractivemuni-ladder
scenariotooltoseehowsamplemuni-bondportf oliosmayperf ormunderdif f erentrisinginterestratescenarios.)
Assimpleasthisapproachappears,ithasbecomemuchmoredif f icultf orindividualinvestorsto
buildmunicipalladdersontheirown.Bef orethef inancialcrisisof 2008–09,investorswouldsimply
purchase‘AAA’ratedmunicipalbondsateachmaturity.Today,‘AAA’ratedbondsaremuchmore
dif f iculttocomeby,asbondinsurancehasbeenmuchlessprevalentandbonddealershave
signif icantlyreducedtheamountof municipalbondsheldintheirinventory.Whatismore,with
yieldsathistoricallylowlevels,‘AAA’ratedbondsmaynotprovideinvestorswithsuf f icientincome
tomeettheirgoals.Giventhesedif f iculties,investorsmayinsteadwanttoconsidera
prof essionallymanagedmuniladder,whichcouldprovidethreekeybenef its:
1. Professionalmonitoringandsecurityselection—NotethattheladderinChart1drawson‘AA’
ratedbonds,giventheshrinkingavailabilityof‘AAA’ratedmunisinthecurrentmarket.With
thereducedsupplyofinsuredbonds,continuousmonitoringandassessmentofthebondsin
theladderbecomesimperative.Aprofessionalmanagercanprovidethoseservicesandthen
useadvancedresearchcapabilitiestoselectappropriatereplacementsformaturingissues.
2. Betterinventoryaccess—Aprofessionalmanagerhasrelationshipswithhundredsofmuni
bonddealersacrossthecountry,givingthemanagerenhancedaccesstobondsthatmight
provedifficultforindividualinvestorstoidentifyandpurchase.
3. Betterpurchasingpower—Aprofessionalmanageralsobuysbondsinbulk,oftenpurchasing
directlyfromtheissuerinsteadofinthesecondarymarket,wheremostindividualinvestors
wouldbuythem.Asaresult,amanagercanpurchasebondsatwholesalepricesinsteadof
individualretailprices.
SummingUp
Forthoseconcernedabouthigherratesinthef uture,amunicipalladderportf oliomaybeworth
considering,asitsstructureisdesignedtobenef itf romsuchanenvironmentovertime.Many
pref eroutsourcingmanagementof theirmunicipalladderportf oliostoprof essionalmanagersin
ordertotakeadvantageof theircredit-monitoringability,inventoryaccess,andpurchasingpower.
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ANoteaboutRisk:Thevalueof investmentsinf ixed-incomesecuritieswillchangeasinterestratesf luctuateandin
responsetomarketmovements.Asinterestratesf all,thepricesof debtsecuritiestendtorise,andasinterestrates
rise,thepricesof debtsecuritiestendtof all.Incomef rommunicipalsecuritiesmaybesubjecttothealternative
minimumtax.Federal,state,andlocaltaxesmayapply.Thereisariskthatabondissuedastax-exemptmaybe
reclassif iedbytheIRSastaxable,creatingtaxableratherthantax-exemptincome.Bondsmayalsobesubjectto
othertypesof risk,suchascall,credit,liquidity,interest-rate,andgeneralmarketrisks.High-yieldsecurities,
sometimescalledjunkbonds,carryincreasedrisksof pricevolatility,illiquidity,andthepossibilityof def aultinthe
timelypaymentof interestandprincipal.Noinvestingstrategycanovercomeallmarketvolatilityorguaranteef uture
results.
ThisMarketViewmaycontainassumptionsthatare“f orward-lookingstatements,”whicharebasedoncertain
assumptionsof f utureevents.Actualeventsaredif f iculttopredictandmaydif f erf romthoseassumed.Therecanbe
noassurancethatf orward-lookingstatementswillmaterializeorthatactualreturnsorresultswillnotbematerially
dif f erentf romthosedescribedhere.
Thismaterialisprovidedf orgeneralandeducationalpurposesonly.Theexamplesprovidedarehypothetical,aref or
illustrativepurposesonly,andarenotindicativeof anyparticularinvestorsituation.
Thereisnoguaranteethatmarketswillperf orminasimilarmannerundersimilarconditionsinthef uture.
Abasispointisoneone-hundredthof apercentagepoint.
Abondladderisatechniquef orreducingtheimpactof interest-rateriskbystructuringaportf oliowithdif f erentbond
issuesthatmatureatdif f erentdates.
Couponistheinterestratestatedonabondwhenit'sissued.Thecouponistypicallypaidsemiannually.Thisisalso
ref erredtoasthe"couponrate"or"couponpercentrate."
ThePersonalConsumptionExpenditures(PCE)Indexisameasureof pricechangesinconsumergoodsand
services.Personalconsumptionexpendituresconsistof theactualandimputedexpendituresof households;the
measureincludesdatapertainingtodurables,non-durablesandservices.
Yieldistheannualinterestreceivedf romabondandistypicallyexpressedasapercentageof thebond'smarket
price.
TheBloombergBarclaysMunicipalBondIndexisarules-based,market-value-weightedindexengineeredf orthe
long-termtax-exemptbondmarket.Theindexisabroadmeasureof themunicipalbondmarketwithmaturitiesof at
leastoneyear.Tobeincludedintheindex,bondsmustberatedinvestment-grade(Baa3/BBB-orhigher)byatleast
twoof thef ollowingratingsagencies:Moody's,Standard&Poor's,Fitch.If onlytwoof thethreeagenciesratethe
security,thelowerratingisusedtodetermineindexeligibility.If onlyoneof thethreeagenciesratesasecurity,the
ratingmustbeinvestment-grade.Bondsmusthaveanoutstandingparvalueof atleast$7millionandbeissuedas
partof atransactionof atleast$75million.Thebondsmustbef ixedrate,haveadated-dateaf terDecember31,
1990,andmustbeatleastoneyearf romtheirmaturitydate.
Indexesareunmanaged,donotref lectthedeductionof f eesorexpenses,andarenotavailablef ordirectinvestment.
Thecreditqualityof thesecuritiesinaportf olioisassignedbyanationallyrecognizedstatisticalratingorganization
(NRSRO),suchasStandard&Poor’s,Moody’s,orFitch,asanindicationof anissuer’screditworthiness.Ratings
rangef rom‘AAA’(highest)to‘D’(lowest).Bondsrated‘BBB’oraboveareconsideredinvestmentgrade.Credit
ratings‘BB’andbelowarelower-ratedsecurities(junkbonds).High-yielding,non-investment-gradebonds(junkbonds)
involvehigherrisksthaninvestmentgradebonds.Adverseconditionsmayaf f ecttheissuer’sabilitytopayinterest
andprincipalonthesesecurities.
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