Fixed Income

Don’t Be Caught Long: Strategies to Curb Interest-Rate Risk in the Municipal Market

By Douglas J. Peebles, Wayne Godlin June 25, 2012

A municipal portfolio full of bonds with maturities in the 20- to 30-year range is exposed today to the high risk of rising interest rates. As my colleague Wayne Godlin explains, now may be the right time to shorten your duration and lower your credit quality.

Since yields are at all-time lows, some investors have been tempted into lengthening duration to earn a little more yield. But this is potentially dangerous, because the longer the duration, the greater the loss in value if interest rates rise.

Yields and prices move in opposite directions, and how much a bond’s price moves when rates change is determined by duration. Duration measures the sensitivity of a bond’s price to changes in the level of interest rates. In general, longer-maturity bonds have longer durations, so their prices rise more if interest rates fall, but also fall more if rates rise. In other words, the longer the duration, the greater the price volatility.

We are particularly concerned about long callable bonds—and virtually every bond with a maturity greater than 10 years is callable in the municipal market. Because of callability, the upside of rising prices when rates fall isn’t equal to the downside of falling prices when rates rise. The display below shows the potential price changes for a 30-year, callable New York State general-obligation bond if rates (and yields) rise or decline by 100 and 200 basis points. The downside, when bond prices fall rapidly in response to rising rates, is much more extreme than the inverse.Price Changes Are Not Symmetrical for Long Bonds

Why is this the case? When interest rates fall, an issuer may be better served by taking out a new loan at a lower rate and using that money to call the bond and repay it early. (Hence, the sharp decline in price.) When rates rise, there’s no incentive for issuers to do anything except hold on to their callable bonds. (Thus the comparative price stability.)

So what do we recommend? We believe the most attractive maturities today are in the three- to 15-year range. As explained in a previous post, a bond appreciates in price as it approaches maturity, and today the value from “rolling down the yield curve” is extremely attractive.

To restore the yield level lost through shortening their portfolio duration, investors should increase their allocation to lower-rated debt. Although the default rate has risen slightly, the wave of defaults once predicted has not materialized. Yet, the extra income medium-grade and high-yield municipal bonds offer is still very high by historical standards. Given these bonds’ greater income in what is otherwise a low-interest-rate environment, we expect investor demand to increase.

In addition, when interest rates rise, lower-rated bonds tend to hold their value better than higher-rated bonds. We believe that investors should take advantage of these bonds’ relatively high income and favorable demand outlook.

Strategies such as shortening duration and moving down the credit spectrum can help mitigate your downside risk if interest rates rise, while preserving your portfolio’s yield level.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.

Don’t Be Caught Long: Strategies to Curb Interest-Rate Risk in the Municipal Market
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