When investors see opportunity, we believe they should actively reposition their municipal bond portfolios to take advantage. Often, this requires selling some existing holdings. Today, financial advisors are asking us: Why do you recommend I sell my clients' long-term bonds? They're yielding 5 percent. Won't selling them reduce my clients' potential return?
These are great questions, and they're ones experts consider in their analysis. Right now, many investors own long-term callable bonds that will likely lose significant value when interest rates eventually rise. Recent research indicates that there is an opportunity to reduce interest-rate risk and earn similar potential returns by employing active management.
Today, interest rates are near historic lows. That means many investors' municipal bond portfolios are loaded with bonds worth more than their purchase price because they were bought when yields were higher than they are today.
When the price of a bond is more than its value at maturity (also known as par value), the bond is known as a "premium" bond. Bonds can be sold for more or less than their par values because of changing interest rates.
For example, an airport revenue bond issued only 2.5 years ago at $98.5 with a 5 percent coupon is priced at $108.4 today, and has a yield of 3.7 percent. This premium bond is expected to pay $100 (par value) upon maturity in 2040.
What makes these airport bonds challenging to value is that they are also callable in 2020. In fact, most long-term municipal bonds are callable. When interest rates descend, long-term callable bonds rally like intermediate-term bonds-because they are priced to their call dates.
Conversely, if interest rates take flight, long-term callable bond values are likely to fall sharply as they begin to price to their long maturity dates.
In this way, long-term premium bonds that are subject to call have the upside of an intermediate bond, but the downside of a long-term bond. This asymmetry of potential returns is most clearly seen in extreme interest-rate movements.
But before that maturity or call date, an investor has the opportunity to sell his long-term bond and pocket a profit.
If an investor takes no action, however, we know how the story ends. He will only be paid par at the maturity or call date-not the higher value. Active managers seek to take these profits and reinvest smartly.
A smart reinvestment today is in intermediate-term bonds, which offer expected total returns similar to those of long-term callable bonds when you consider both yield and price return from roll.
Roll for intermediate-maturity bonds is worth 1.7 percent today. Together with yield, the expected return of an intermediate bond is 3.7 percent-essentially the same as the yield of a long-term callable bond. Furthermore, in selling the long-term bond and reinvesting the proceeds in an intermediate-term bond, the investor has reduced his interest-rate risk.
Investors want consistent income and stability from their bond portfolios. By actively redeploying some long-term municipal bonds and navigating to a more attractive part of the yield curve, we believe investors may be able to achieve similar returns and increase the stability of their portfolio.
Guy Davidson is director of municipal investments at AllianceBernstein.