After what appears like without end, the yield curve has reverted to its normal direction, with longer-dated bonds now yielding greater than shorter-dated ones. For income seekers, this is critical, because it means the times of finding 5%+ yields in short-term securities at the moment are.

But that doesn’t mean that there aren’t good income opportunities on the market — especially whenever you consider taxes.

Immediately, and due to the yield curve returning to normal, long-dated municipal securities could offer a few of the very best total return elements of any fixed-income asset class around. The flexibility to generate high tax-free yields alongside capital gains makes them a compelling selection for investors.

The Yield Curve Flips

For the last two years, the Fed has continued to boost benchmark interest in an try to cool the economy, increase borrowing costs, and fight inflation. This has had an interesting effect on the yield curve and short-term bonds.

The yield curve in its simplest form is a plot of current yields of assorted fixed-income securities of comparable credit quality. Normally, the yield curve is upward-sloping. Longer-dated securities will yield greater than shorter ones. The thought is that investors want more yield to compensate for the long maturity profile and the unknowns that include holding bonds 7, 10, or 30 years away from maturing.

But with the Fed raising benchmark rates to levels not seen in a long time, the yield curve flipped. T-Bills and other short bonds were yielding more, and with the surge in short-term rates and bonds, longer-dated bonds fell by the wayside.
Today paints a really different picture for the yield curve and bonds.

With the Fed cutting rates and the bond market carnage, the yield curve is beginning to correct itself. For instance, the 10-year Treasury bond is now yielding around 4.03% — above the 3-year bond at 3.95%. And while very short-dated bonds, resembling the 3-month T-bill, are yielding greater than longer-dated ones, their yields have dropped significantly during the last 12 months — falling about 75 basis points during the last 52 weeks.

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Long-Dated Munis Win

The shift within the yield curve can profit many longer-dated bonds as investors rush to search out income. Nonetheless, long-dated munis may offer a number of the strongest sets of wins for all investors.

For starters, long-dated munis have a number of the highest durations out of any bond category. Duration is the measurement of a bond’s rate of interest risk that also considers aspects like a bond’s maturity, yield, coupon, and call features. Duration will be used to determine how far a bond will fall when rates rise, and vice-versa. In periods of rising rates, a high duration can kill returns. But in periods of falling rates, it really works the alternative way by providing strong returns.

Many municipalities and states issued loads of muni bonds with long maturities to benefit from the ZIRP environment of the last decade. With that, the ICE Long AMT-Free Broad National Municipal Index, which tracks long bonds, has a modified duration-to-worst of 13 years. That’s the longest duration for the index within the last ten years and has boosted the index’s sensitivity to rates of interest in an enormous way.

After the abundance of issuance, states and native governments have stopped issuing long bonds. Supplies of those bonds have come to a trickle as many governments don’t need to lock in high interest expenses for a long time.

Along with the potential for duration-propelled price increases and provide constraints, long munis are paying some very juicy yields. The bond type is currently yielding over 4%, putting it ahead of many bond categories, including Treasuries, which have an analogous credit profile. What’s truly amazing is that this headline yield only tells a part of the story.

Muni bonds are free from Federal and in lots of cases state taxes. This provides them with a high after-tax equivalent yield. Today, that after-tax yield is as high as 7% for those in the highest tax brackets. And with the Tax Cuts and Jobs Act possibly sunsetting, this after-tax yield becomes excellent for taxpayers. Immediately, long-dated munis’ current after-tax yield makes them a more sensible choice than corporate bonds, Treasuries, and the Bloomberg Aggregate Index for investors within the 24% tax bracket.

All of this sets up a robust total return profile for long-dated munis. Taking a look at historical data, asset manager Van Eck shows that long-dated munis have been the highest performers versus other bonds when the Fed starts to chop and change into dovish with its rate of interest policies. This chart highlights their findings.

Making a Long Bond Play

With the Fed beginning to cut rates and the yield curve returning to normal, long-dated municipal bonds are the clear winners of this policy change. Due to their high current yields and rate of interest sensitivity, they’ve the flexibility to supply a robust total return for portfolios. The most effective part is there continues to be time to capture the sector’s potential.

The yield curve hasn’t officially gotten back to normal, because the short end continues to be top-heavy. But that may and will change when the Fed cuts again. That makes buying long munis an excellent decision.

The query is tips on how to get that exposure. The muni market stays difficult for investors to tap individually. Which means using a fund or expert to get that exposure. And even here, it will possibly be difficult. The variety of long-date muni funds has continued to shrink as many have been rolled into other intermediate or broad muni strategy funds.

Long-Dated Muni Bond Funds

These funds were chosen based on their exposure to the long-dated muni bond universe. They’re sorted by their YTD total return, which ranges from 0.7% to 1.9%. They’ve expenses between 0.09% and 0.28% and assets between $27M and $17.1B. They’re currently yielding between 3.3% and 4%.

Overall, changes to the yield curve mean changes to portfolios. And right away, long-dated munis offer the very best combination of wins for investors. This includes higher after-tax yields and the potential for duration-induced price gains. For investors trying to make probably the most out of the changes to the yield curve and the brand new Fed policy, these bonds can’t be beat.

Bottom Line

After the yield curve’s inversion, several fixed income securities are beginning to regain their leading positions, especially long-dated municipal bonds. Offering long durations, higher yields and powerful credit quality, these bonds may very well be big winners because the Fed cuts rates further and the yield curve returns to normal.