Navigating muni bonds: Three potential paths to success

With a team of more than 20 credit analysts, research is one of the primary strengths of Vanguard’s Fixed Income Group. We look to identify mispriced issuers with strong or improving fundamentals and those for which higher yields compensate investors for the extra risk taken.

From a credit perspective, we see ample opportunity in muni bonds. High-income U.S. investors dominate the tax-exempt market, where many tend to buy bonds individually or as part of separately managed accounts. Those investors gravitate primarily to AAA- and AA-rated bonds in order to minimize credit risk. But that behavior means that lower-rated bonds, which are often overlooked, may offer better-than-expected yields.

Our take on credit:

• We think the best value for municipal credit spread is in bonds rated A and below.
• Research and security selection can add value at any credit level of the muni market.

Carry can encompass a few strategies. Most simply, it can mean holding securities that outyield a benchmark, often by adding beta from credit or duration. Carry can also involve optimizing positions at different points in the yield curve based on roll-down—the increase in a bond’s value as it approaches maturity.

Our take on carry:

• Given the current interest rate outlook, we expect carry to play an important income-generating role in our portfolios.

When interest rates change, a bond’s price can fluctuate. We measure this sensitivity to rate changes as duration. But for municipal bonds with call options, duration can be far from constant; the extent to which duration can change for a given bond is referred to as convexity.

Here’s an example. Let’s say an issuer’s option to call a bond early goes “out-of-the-money” because market yields rise above the bond’s coupon level (why would an issuer want to refinance debt at a higher rate?). The duration for this security could rise from eight to 15 years as market trading adjusts from an expected life of 10 years (call date) to that of 30 years (stated maturity).

It’s difficult to measure and manage this risk for tens of thousands of bonds, which is why many municipal bond investors (direct retail investors, managers of separately managed accounts, even many asset managers) usually try to avoid these risks. The resulting mispricing of convexity leads to opportunities for constructing a portfolio offering benchmark-relative alpha potential without the downside risk.

In sum, a callable municipal bond’s sensitivity to interest rate changes can rise (or fall) as market yields take large swings, especially when they cross over (or under) the coupon rate.

Our take on convexity:

• In the muni market with thousands of callable bonds (roughly 80% of the market), convexity is a complex but meaningful factor in valuations. Only a sophisticated active manager can model forward pricing and act on opportunities.
• Our team has decades of experience analyzing convexity; for us, it’s a key element in managing duration risks and extracting value.

Like a savvy cabdriver who uses their own knowledge and awareness to help navigate complex city streets, we use our experience with credit, carry, and convexity to unlock value for Vanguard’s muni fund investors.

Our job as an active manager is to use the flexibility of these three levers to take advantage of opportunities as they arise, even as we do the traditional work of analysis across sectors, regions, and issuers.