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Today’s interest rates: a challenge for muni laddered bonds
Greg Ortman
Fixed Income Investment Director
Jose Guzman
Product Specialist - IPM
KEY TAKEAWAYS
  • The municipal bond yield curve rarely inverts but has been inverted since mid-December 2022.
  • One-year AAA general obligation (GO) municipal yields are currently higher than their 10-year counterparts.
  • An inverted yield curve creates challenges for laddered portfolios that buy generic municipal bond risk.
  • We believe laddered bond investors could benefit from considering active management.

Muni yield curve remains inverted in 2023


After the Fed hiked rates by 50 basis points (bps) in December, short-term municipal (“muni”) rates rose, and the muni bond curve inverted. The curve is said to be inverted when short-term yields deliver higher yields than long-term yields. In late February, 1-year AAA GO municipals, for example, yielded 53 bps more than 10-year AAA GO municipals. An inverted municipal curve is very rare, but the curve has been inverted since mid-December 2022. Municipal curves do not normally invert, because tax-exempt investors are normally focused on generating income and are not typically willing to take on more interest rate risk in exchange for less income. Inversion in the U.S. Treasury curve is much more pronounced and common to see in a rising-rate environment.


Like the Treasury yield curve, much of the muni yield curve is inverted

⬤   U.S. Treasury

⬤   U.S. Treasury - 1 month earlier

⬤   Muni AAA GO

⬤   Muni AAA GO - 1 month earlier

This chart illustrates the muni yield curve inversion in February 2023. The chart includes yields and maturity data points for Muni AAA GO; Muni AAA GO 1 month earlier; U.S. Treasury; and U.S. Treasury 1 month earlier. Maturity data points on the X axis include 3 month, 6 month, 1 year, 2 year, 3 year, 5 year, 7 year, 10 year and 30 year; yield data points on the Y axis are 2% through 6%. For Muni AAA GO, the 1-year maturity has a 3.15% yield and the 10-year maturity has a 2.62% yield, 53 basis points less than the 1-year maturity, representing the yield curve inversion. For Muni AAA 1 month earlier, the 1-year maturity has a 2.34% yield, and the 10-year maturity has a 2.24% yield. For the U.S. Treasury, the 1-year maturity has a 5.03% yield, and the ten-year maturity has 3.92% yield. For the U.S. Treasury 1 month earlier, the 1-year maturity has a 4.68% yield and the 10-year maturity has a 3.51% yield.

Source: Bloomberg. As of 2/22/2023. Yields shown for U.S. Treasuries and the baseline curves for BVAL tax-exempt munis.

Curve inversions and laddered portfolios


The concept of a typical laddered bond portfolio is straightforward. A laddered bond portfolio is a portfolio of fixed income securities with each security maturing on a different date. The intent is to hold each bond until it matures. As bonds mature, the investor reinvests the proceeds into a long-term bond with a higher yield.


This strategy, of course, assumes an upward-sloping curve where the investor can increase their income by purchasing bonds on the longer end of the yield curve. As a result, the laddered bond approach tends to be the most effective when the curve is steeper. However, when the curve is inverted like in 2023, with shorter bonds having higher yields than longer bonds, the laddered bond investor is forced to buy longer term bonds at lower yields, falling short of the goal to achieve higher income potential by adding longer term bonds.


The benefit of active management in munis


An inverted curve makes a case for considering active management in many aspects of a municipal portfolio. Consider an actively managed municipal bond portfolio like those in our mutual funds, exchange-traded fund (ETF), or separately managed account (SMA) suite. Actively managed strategies can seek to avoid the pitfalls of a laddered bond portfolio in a higher volatility environment where the curve is inverted.


In a portfolio like Limited Term Tax-Exempt Bond Fund of America® or the Capital Group Intermediate Municipal SMA, for example, the investment teams currently see less value in the 3- and 5-year portions of the curve and hold a smaller portfolio position relative to its benchmark. These portfolios hold a greater weighting in the very short end of the curve (less than 1-year) and parts of the longer end (+10-years) where managers believe there is more value. Additionally, the teams are still able to find idiosyncratic risk opportunities in those parts of the curve where they have relatively less exposure. There, managers focus investments on specific issuers they find more attractive than others to prevent the exposure in the 3- and 5- year portions of the curve from going to zero. An example of this is single-family municipal bonds that have very wide spreads (which offer much higher yields than comparable AAA municipal bonds) and an average life of less than 5 years. For these reasons, we believe the current environment and foreseeable future provide a strong case for investors to consider active management in the municipal market, especially for those invested or interested in a laddered bond approach.*


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Published on March 31, 2023

Greg Ortman is a fixed income investment director with 27 years of industry experience (as of 12/31/23). He holds a master’s degree in economics from Claremont Graduate University and a bachelor’s degree in economics from St. Edwards University.

Jose Guzman is an investment product management specialist with 8 years of industry experience (as of 12/31/2023). He holds a master's degree in philosophy from California State University, Los Angeles and a bachelor's degree in philosophy from University of California, Los Angeles. 

Additional perspectives

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* The mutual fund shares the same investment objective and many of the same portfolio managers with the respective SMA. Tax treatments, expenses, and minimum investment amounts, among other things, differ between the vehicles. SMAs are not registered investment products sold under a prospectus.

Past results are not predictive of results in future periods.

The BVAL tax-exempt muni curve is populated with high quality U.S. municipal bonds with an average rating of AAA from Moody’s and S&P. The yield curve is built using non-parametric fit of market data obtained from the Municipal Securities Rulemaking Board, new issues calendars and other proprietary contributed prices.