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

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.

Douglas J. Peebles

Chief Investment Officer and Head—AllianceBernstein Fixed Income
Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer and Head of AllianceBernstein Fixed Income. In this role, he supervises all of the Fixed Income portfolio management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within Fixed Income, including director of Global Fixed Income from 1997 to 2004 and co-head of AllianceBernstein Fixed Income from 2004 until 2008. He holds a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

Wayne Godlin

Portfolio Manager—Fixed Income
Wayne Godlin joined AllianceBernstein in 2009 as a member of the Municipal Bond Portfolio Management team. He helps design and manage the firm’s municipal investment strategies and customized product solutions to serve the needs of financial advisors and clients. Godlin joined the firm with more than 26 years of investment experience, including 21 years with Morgan Stanley Investment Management, where he was head of the Municipal Bond team. Most recently, he served as chief municipal strategist and as a portfolio manager for the high-yield municipal fund at Van Kampen, an investment-management unit of Morgan Stanley. In the past, Godlin worked with Hanifen Imhoff in Denver, where he focused on structuring financing plans for new-issue and refunding transactions. He also served as a municipal research analyst in public finance with First Interstate Bancorp. Later, Godlin worked with American Capital Asset Management as a senior municipal credit analyst for high-grade, mid-grade and high-yield municipal credits. He holds a BA from Union College and an MPA from Columbia University. Location: New York

Related Posts