2022 has been a historic year for fixed income markets, given the magnitude and speed at which yields have moved higher from near zero. The brunt of the move has been felt on the short end, as the Fed has clearly outlined a hawkish path to tackle much higher than desired inflation. Through September 26th, the 2-year UST yield has increased by a whopping 354 bps, while the AAA MMD 2-year spot has increased by 278 bps. Additionally, the yield on the ICE BofA 1-3 Year Muni Index has increased by 292 bps. While the adjustment higher in muni yields has been at a less extreme nominal level, it is important to consider that the AAA muni/Treasury relative value ratio has actually increased significantly. Looking again at the 2-year spot, the muni/Treasury ratio has moved from an anemically low 33% at the start of the year to 70% as of close on 9/26/2022.
Source: US Treasury, ICE Data, Bloomberg
While this adjustment higher in yields has left few places to hide from a performance perspective, we want to remind clients that we believe this has created income opportunities for long-term investors not seen in some time. Staying with the theme of short-end rates, we have again compared the 2-year UST to the ICE BofA 1-3 Year Muni Index, which have comparable duration characteristics (as of 9/26/2022, modified duration to worst 1.90 for 2-year UST and 1.80 years for ICE BofA 1-3 Year Muni Index). As of September 26th, the 2-year UST yield closed at 4.27%, while the ICE BofA 1-3 Year Muni Index closed at a YTW of 3.33%. Assuming a maximum Federal rate, this equates to a taxable equivalent yield of 5.63% - 136 bps above the comparable Treasury tenor. Thus, while the 2-year UST yield is eye-opening at levels not seen since 2007, we argue that munis continue to offer value for higher tax-paying investors.
“Thus, while the 2-year UST yield is eye-opening at levels not seen since 2007, we argue that munis continue to offer value for higher tax-paying investors.”
Source: US Treasury, ICE Data, Bloomberg, APA
To extrapolate this out further, we have compared the after-tax income on a hypothetical Treasury purchase to the tax-exempt yield of the index. As is detailed in the table, on a $1 million investment, a client could earn an approximate additional $8,000 in annual after-tax income in this comparison.
Source: US Treasury, ICE Data, Bloomberg
Finally, we want to remind clients that metrics continue to support muni credit being on very sound footing. COVID 19-related stimulus is still being allocated and spent by local governments, while revenue collections remain above trend. As a result, rating agency upgrades significantly outpaced downgrades in the 18-month period of 2021 through Q2 2022. While a hypothetical economic slowdown could pressure this trend as we look forward to 2023, we believe high-quality municipalities are well-positioned to weather the storm, with cushion from recent large-scale fiscal stimulus.
Disclosures:
Past performance is not indicative of future results. Investing involves risk including the potential loss of principal. This material is not financial advice, or an offer to sell any product. The actual characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market exigencies at the time of investment. Asset Preservation Advisors, Inc. reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This is not a recommendation to buy or sell a particular security. There is no assurance that any securities discussed herein will remain in an account's portfolio at the time you receive this report, or that securities sold have not been repurchased. The securities discussed may not represent an account's entire portfolio, and in the aggregate may represent only a small percentage of an account's portfolio holdings. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable, or will equal the investment performance of the securities discussed herein. Information was obtained from third party sources which we believe to be reliable, but are not guaranteed as to their accuracy or completeness.
APA is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill of training. More information about the advisor including its investment strategies and objectives can be obtained by visiting www.assetpreservationadvisors.com. A copy of APA's disclosure statement (Part 2 of Form ADV) is available without charge upon request. Our Form ADV contains information regarding our Firm’s business practices and the backgrounds of our key personnel. Please contact APA at 404-261-1333 if you would like to receive this information.
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