An Active Approach to an Unconventional Muni Yield Curve

[Mike Spitz] Thanks everyone for joining this episode of the “Segall Bryant Hamill Municipal Insights Podcast”. I’m your host today. My name is Mike Spitz, I’m the Director of National Accounts and Distribution here at Segall Bryant and joining me is our Head of Municipal Portfolio Management, Nick Foley. Nick, thanks for joining us.

[Nick Foley] Absolutely. Happy to be here.

[Spitz] Nick, let’s start off with some one-on-one talking about the yield curve. I mean, as investors, we’re frequently hearing about the shape of the Treasury yield curve and how that’s inverted right now. So, let’s discuss that and then adding on to that, let’s talk about the yield curve that you and the municipal market use, the Municipal Market Data (MMD) or AAA yield curve and the shape of that yield curve. Let’s start again with the 101s on inverted Treasury yield curves and what that means.

[Foley] Yeah, absolutely. So a big topic discussion right now, obviously, but essentially, at the end of the day, a yield curve is just how much should I get paid in yield to lend money to someone as you go out further in time. So, obviously very comfortable doing it for six months or a month, but then expecting to get paid a little bit more if I lend money out for five years and then 10 years and then 30 years. So, you’re expecting that you would get paid more money to lend money out to someone for longer and longer time frames as you’re locking that money up. And obviously, a lot of things happen during those times. So generally, what that looks like in a visual sense is this upward sloping yield curve where the lowest yields are at the front, and then it goes up and up and up. And the longest maturity, say 10 or 30 years, you get a significantly higher yield. An inverted yield, and we call that again, a positive sloping yield curve. An inverted yield curve is the opposite of that, where what you’ll see is the short end yields are significantly higher than, say, the 5-, the 10-, and the 30-year yields. So, you’re being paid the most from a yield basis to lend the shortest, which is a unique phenomenon. It happens fairly frequently in the Treasury market. What’s unique is that in the municipal market, we have something called the AAA municipal bond curve. It’s our Treasury curve, essentially. So, it’s every time you buy a bond that isn’t AAA, you’re expected to get paid a little bit more for that credit risk. So, everything is spread off of that AAA yield curve. What’s unique is that the AAA muni curve almost never inverts. It’s very, very rare that it inverts at all. And when it does invert, it’s generally very brief, and very mild, and more just looks flat, or maybe a couple basis points lower as you get out, nothing dramatic. But what we’re seeing is totally unprecedented, where what we’re seeing is unique in the sense too, and different from Treasuries in the sense that what we’re seeing is that the yield falls as you go out to about 3 years. And then it’s flat essentially from 3 to 9 years. So fully inverted. But the fascinating part is then it’s reverting to a positive sloping yield curve. So, what it looks like, we’ve designated it the Big Dipper. I’m not sure that’s a factual name you’ll find in a textbook, but the point is that it’s extremely unique in the context versus Treasuries in that the Treasury inversion looks like a line that goes out and stays inverted. In fact, a lot of the time, 10s will still have a higher yield than 30s. So, it continues to invert versus in munis, this yield curve that’s going down and then back up, it creates a unique curve and some interesting opportunities.

[Spitz] Thanks, Nick. So, you said this before, and I want to be clear on it. We hear about the inversion of the Treasury curve, which has happened many a times in the past, it’s been an indicator of a pending recession. We haven’t seen the AAA yield curve invert the way it is today, correct?

[Foley] Correct. Not at all. Nowhere in history can I find data that we’ve seen anything like this.

[Spitz] So, just given the shape of the AAA curve, let’s talk about investors using static strategies, or what we commonly call laddered strategies. How are they putting themselves at a disadvantage due to the shape of the curve given a concept known as negative roll? And how are you as an active manager exploiting that shape of the AAA curve?

[Foley] Yeah, absolutely. So, we think one of the things that’s driving this very unique shape that again, you just generally wouldn’t ever see in the Treasury market is that it’s really being driven actually by some of these more rules based SMA strategies. We’ve seen a massive growth in institutional SMA strategies. But the point is that in order to build thousands and thousands and thousands of SMAs as they come in, you need to do it in a sense where it’s very rules based. And what I mean by that is, say if you come in and you do a one to 10-year municipal bond SMA, what happens is that, again, when you bring your money in, they go and they buy you a 1-year, a 2-year, a 3-year, or 4- or 5-year, all the way out to 10-years. And they have these buckets, and they fill them, and that’s great. The issue is that when you have lots and lots of money going into those strategies is that they become essentially agnostic buyers to relative values. So, it doesn’t really matter that you can get a lot higher yield than a 12-year bond than a 9-year bond. You just go out and you buy the 9-year bond. We think with one of the things that’s driving this very odd shape of the yield curve is this massive amount of non-economic buyers that just are trying to fill buckets. So, from our chair and what we do, we think it really creates an opportunity. We think that just in a very even simplistic way, thinking about it, is that you can do something called a barbell where you can own short-end bonds that are yielding significantly more than yields as you go out a little bit in maturity. And then you can own the other side of the yield curve that has a positive-sloping yield curve. So, why that’s so important is that if you think about it, one of the beautiful things about bonds is that you get paid just to hold it over time and it’s not just the yield. So, roll is the common name for it, but essentially what that means is that in a positive-sloping yield curve, if I buy a 10-year bond, and I just hold onto it for one year, it become a 9-year bond. Well, people in a positive-sloping yield curve are willing to pay a lower yield for a 9-year bond versus a 10-year bond. So, you’ve just naturally gotten price appreciation as that bond has just naturally has gotten shorter. Now, the nasty thing in inverted curves is that, for example, right now if you buy a 3-year bond and you hold it, the yield that’s demanded by the market currently is higher for a 2-year bond. So, this can be called a negative roll, where the price that’s being asked needs to fall as you’re holding that bond. It works in the negative direction and inverted yield curve. So again, by building say even a barbell where you can get that positive slope, higher yields by going out, avoid that part of the curve where you’re getting negative roll. And then on the very short part of the yield curve, you can get an interest rate profile that looks the same, or maybe even has a little bit less interest rate risk, but again, continue to be capturing that positive roll higher yields.

[Spitz] Got it. Thanks, Nick. So, avoid the big dipper. It’s definitely an interesting time in the municipal market, just given the shape of the curve. It’s a good time to go active in the municipal market. So, I want to thank everyone for joining us today for our municipal insights podcast. If you do have questions on this concept of negative roll or the shape of the yield curve or even our active municipal strategies, please feel free to reach out to Segall Bryant sales contact, or you can find us online at sbhic.com. Thanks.