Short-Term Munis Are Paying Highest Yields Since December 2007

(Bloomberg) — The last time one-year municipal bond yields were this high, Alicia Keys was at the top of the Billboard charts, the New England Patriots were on their way to a perfect regular season and George W. Bush was president.

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The Federal Reserve’s campaign to stamp out inflation has driven yields on top-rated one-year munis to around 3%, close to the highest since December 2007, and investors should take notice, according to Western Asset Management Co.

Not only are absolute yields close to 15-year highs, the muni yield curve is relatively flat, meaning investors on the short-end can reap the benefits of higher-yields without taking much duration risk. Investors buying longer-maturity debt have to deal with bigger price swings if the central bank keeps raising rates and the yield curve moves higher.

“As the Fed is trying to normalize their rate policy and adapt to a higher inflation rate environment, there’s just a lot more income available to investors” said Robert Amodeo, head of municipals at Western Asset Management. “The flatness of the curve is also offering appeal to those investors who want to have shorter durations in their portfolio.”

Yields on one-year AAA bonds, 18 basis points at the beginning of the year, have surged by around 2.8 percentage points as the highest inflation in four decades and the Federal Reserve’s campaign of aggressive interest-rate hikes sparked a roughly $100 billion flight from muni mutual funds. Last week, one-year AAA yields topped 3%.

The rate hikes also caused the muni yield curve to flatten as short-term yields, which can be more closely tied to Federal Reserve policy, rose higher. The difference in yield between 2-year AAA munis and 10-year AAA munis hit 15 basis points Oct. 4, the lowest since March 2020, at the onset of the Covid-19 pandemic, according to data compiled by Bloomberg.

The appeal of short-term tax-exempt municipal bonds is even greater for investors in the top tax brackets, who derive greater benefits from the tax-exemption at higher nominal rates, according to John Mooney, a portfolio manager at Western Asset Management.

A 3% tax-exempt bond maturing in one year has an after-tax yield of about 5% for investors subject to the highest federal tax rate of 37% plus the 3.8% Medicare surtax. Treasuries maturing in one year have an after-tax yield of around 2.35%.

Before this year, when short-term rates were close to zero, muni investors seeking income had to buy long-dated bonds.

“Folks were forced to kind of endure a lot of price volatility to get those 5% after-tax levels. That’s not the case any more,” Mooney said.