The continued decline in Treasury rates added to a third quarter of positive returns for municipal bonds. The Bloomberg Barclays Aggregate Bond Index posted a return of 8.72% through the end of 2019. The Bloomberg 5-year Municipal Bond Index returned 5.45% for the year. Investors took notice and poured $90 billion into municipal bond mutual funds versus $4 billion in 2018.
The quarter began with the Bloomberg Municipal AAA curve at 1.45% and ending at 1.47%, just two basis points higher. The muni yield curve steepened during the quarter. As you will see, the real steepening was in the first five years of the curve where investors pushed ratios to 60-70% of Treasuries. Here are the Bloomberg AAA yield curve changes during the quarter.
|Years||Quarter Ending 9/30/19||Quarter Ending 12/31/19||BPS Changes|
|1 Yr||1.24%||1.03%||- 21 BPS|
|5 Yr||1.24%||1.11%||- 13 BPS|
|10 Yr||1.45%||1.47%||+2 BPS|
|20 Yr||1.83%||1.88%||+5 BPS|
|30 Yr||2.02%||2.10%||+8 BPS|
Source: Bloomberg, Ned Davis Research
As the curve steepened in October and November, the strategy underperformed its benchmark. December was in line as the portfolio benefited from the yield curve roll that happens every January as the optional call feature which premium bonds are priced to moves down the yield curve.
In our view, munis provide some of the best credits in the global fixed income arena. Munis react more to macro events such as tax law changes and yield curve shifts for example rather than to specific credit events. This year is a good example as Illinois and New Jersey, the states with the biggest headline risk, provided some of the best returns in the municipal market. The reason for this is that higher equity prices helped tamp down the talk of pension liabilities and low rates had investors looking for the highest yields available.
Tailwinds are still prevalent in munis although these should be more muted in 2020 as we are starting from overall lower Treasury yields than at the start of 2019. Credit quality deterioration should be minimal with full employment and a slow growth economy. Tax advantages will continue to keep individual demand strong.
Taxable new issue supply is a credit positive in our view. Municipalities continued to issue 5% coupons in the tax-free market for decades, not really taking advantage of lower interest rates. A shift to taxable issuance with current coupon structures should lower overall true interest costs to issuers. Lastly, the Fed appears to be accommodative.
As we enter 2020, we will continue our barbell approach to investing our SMA accounts and we believe this strategy is in line with our CIO Sean Clark’s interest rate outlook of a 10-year Treasury range of 1.50% -2.50%. 2.50% is cheap money, but it doesn’t feel that way when you move from 1.50% to 2.50%. Therefore, we believe active management versus a passive strategy warrants consideration.