By Guy Davidson

Municipal bonds have rallied in 2014, but low yields, memories of last years sell-off and the potential for
higher rates ahead have many investors wondering how to maneuver. We have a couple of ideas.
Bonds still play a key role in most investors portfolios, so lets look at some facts: First, the sell-off wasnt
driven by poor fundamentals, but by outflows related to miscommunication by the US Federal Reserve about
when the bond tapering would begin. And second, muni bond yields particularly long-term muni bond
yields have historically risen by much less than the fed funds rate. As a result, theyve done fairly well in
periods when the fed funds rate has risen (Display 1).
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2 Things Municipal Bond Investors Can Do Today
Mar. 26, 2014 11:32 AM ET | 1 comment | Includes: MUNI by: AllianceBernstein
2 Things Municipal Bond Investors Can Do Today - Seeking Alpha http://seekingalpha.com/article/2110453-2-things-municipal-bond-invest...
1 of 5 3/27/2014 12:52 PM
But with rates low and likely to rise, how can investors enhance their returns? Those looking for higher
income should consider investing in muni high-yield bonds. For more conservative investors, we think that
reducing interest-rate risk in a high-quality bond portfolio makes sense.
Add Higher-Yielding Municipals
Longer-maturity bonds have historically been fairly insensitive to changes in the fed funds rate, but they also
have the greatest interest-rate exposure. Within long-maturity bonds, one sector stands out: high-yield
municipal bonds, which offer a 3.3% higher yield today than AAA-rated bonds of the same maturity. The
average yield advantage of high-yield muni bonds over the last 18 years has been just 2.4%.
High-yield bonds offer more income today than usual, and we expect high-yield issuers credit quality to
generally improve in a strengthening economy.
But what about credit risk? Last year, concerns about Detroit and Puerto Rico helped create a sell-off that
caused long-term, high-yield bonds to underperform. The underperformance wasnt due to fundamental
problems, though. In fact, the credit quality of most states and local governments has improved along with
the economy, as we expected it would. Municipalities have seen 16 straight quarters of year-over-year tax
revenue growth, and tax collections are very high. This upswing and the dissipation of concern over
headline events should spur even more demand for municipals.
For these reasons, we see long-maturity, high-yieldbonds as a good opportunity for investors who want to be
defensive but are looking to boost their income today.
Find the Sweet Spot in Intermediate-Term, High-Quality Bonds
For more conservative investors, we think that it makes sense to reduce interest-rate risk by selling long
bonds and using the advantages of intermediate-term municipals to enhance returns. What makes this
proposition difficult for most investors is the reduction in yield that this repositioning implies. But, a lower
yield doesnt necessarily mean that you end up with a lower return.
A key piece of the puzzle is roll, the natural price gain a bond experiences as it moves closer to maturity.
Todays very low short-term rates mean that the intermediate part of the yield curve is steep, particularly for
2 Things Municipal Bond Investors Can Do Today - Seeking Alpha http://seekingalpha.com/article/2110453-2-things-municipal-bond-invest...
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bonds with five- to eight-year maturities. The steeper the yield curve, the more powerful roll can be. If we
combine the return potential from both income and roll, the expected returns of intermediate-term and
long-term bonds are similar. In fact, while absolute yields may be low, expected returns from roll plus yield
for intermediate-term bonds are attractive (Display 2). Of course, there are many other factors that impact
muni bond returns.
So, while municipal yields may be lower today, investors can still build bond portfolios that offer good
potential returns without taking too much interest-rate risk.
The views expressed herein do not constitute research, tax advice, investment advice or trade
recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management
teams. Past performance of the asset classes discussed in this article does not guarantee future results.
Guy Davidson is Director of Municipal Investments at AllianceBernstein (AB).
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Comments (1)
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IncomeYield
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Comments (1380)
"What makes this proposition difficult for most investors is the reduction in yield that this repositioning
implies. But, a lower yield doesnt necessarily mean that you end up with a lower return."
What makes this "difficult" is paying the bills. :)
And the inherent costs of trading munis.
26 Mar, 01:17 PMReplyLike0
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