The municipal debt markets are comprised of a wide array of issuers and their respective debt instruments, which are often unique in terms of bond ratings, debt structures, and yields.
As these characteristics can vary with each issue, it can present various investment opportunities for investors. They also present different types of challenges for investors to examine before making their investments decision. Thus, investors rely heavily on market indices, benchmarks and yield curves to analyze their potential investments and perform comparative analysis of different issues and sectors of the municipal debt markets.
In this article, we’ll take a closer look at the yield curve as an index and how it can be quite helpful in municipal bond valuations.
What is a Yield Curve?
A yield curve is a representation of different interest rates for bonds with different maturities. When we plot all these maturities from the smallest to the largest on one x-axis and interest rates from lowest to highest on the y-axis, the resulting graph is a yield curve.
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A yield curve is a good indicator of market supply and demand of bonds with different maturities and is typically based on the yields of these bonds trading in the market or their yield estimates. For example, short-term debt instruments are known to offer lower yields and long-term bonds to offer relatively higher yields; hence, the normal yield curve is upward sloping as shown below.
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Yield Curves and Bond Pricing
In addition, since bond prices and bond yields are inversely correlated, there are different factors that impact both the short and long ends of the yield curve, contributing to the eventual shape of the curve.
The short end of the yield curve is heavily influenced by the monetary policy of the Federal government, i.e. the interest rate policy. If the Fed is expected to increase rates, the short-term rates on the yield curve rise, and they would fall if the Fed is expected to lower interest rates. Similarly, long-term yields are more influenced by the long-term outlook of the U.S. economy. In general terms, these economic outlooks entail everything from economic growth, inflation expectations, and the supply & demand in the market for long-term bonds (which also showcase investors’ risk appetite for longer maturities). At any given time, when economic growth is slow with lower inflation expectations, it tends to create less demand for longer maturity bonds. Subsequently, the long-term yields fall. Along the same lines, if the economic outlook is positive and the economy is booming, it tends to create higher inflation and investor demand for longer maturities increases. This pushes longer-term yields up, while prices for longer maturities tend to fall.
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Although, government policies and economic outlooks have always had an enormous impact on yields of various maturities, there are other variables that are integrated into the bond yields. The difference between the yield assigned to a particular issue and the benchmark yield, based on the maturity of that debt instrument, is called the risk-premium or the yield spread.
Some of the key factors influencing bond yields include:
- Credit quality: Credit quality is one of the most important factors integrated into bond valuation, and it plays an important role in determining the yield of that particular issue. The ratings are assigned to debt issuances to communicate the potential risks associated with each debt. The credit quality and the yield for any debt are inversely correlated. For instance, when credit quality is high, bond yields tend to be lower.
- Type of debt and its structure: The structure of any debt issuance is critical in its price and yield valuations. A debt secured by specific streams of revenue to meet its debt service tends to be a safer investment in an economic downturn than a debt structure that’s backed by general tax revenues.
- Tax status and call features: It’s also important for investors to understand the tax benefit of the debt instruments and the callability of that instrument – both of which play important parts in the yield and price valuation.
It is interesting to note that the Municipal Securities Rulemaking Board (MSRB) has recently taken proactive steps to have municipal data reported daily and projected onto a “Real-time Yield Curve” to provide better transparency in the municipal debt markets. This is a positive step toward leveling the playing field both for larger and smaller investors as they will have better access to pricing information to make informed investment decisions.
In addition, considering the relatively illiquid nature of muni markets, a yield curve is the critical part of debt pricing, quoting bond prices, and determining yield spreads for investors and issuers. The new live yield curve is largely driven by the muni market’s up-to-date data and market polls. Market activity of dealer-provided ask-prices of traded bonds is reflected in the curve everyday.
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The Bottom Line
Yield curve and other benchmarks can effectively be used for evaluating bond prices and yields. This information is critical for issuers in their preparations for and during the bond pricing process and setting up baselines to establish yield levels for their new issuances and comparative bond pricings. For investors, the municipal debt sector has been a good safe haven, mainly due to the market and political uncertainties along with the relative safety of municipal debt. However, the illiquidity of the municipal debt market, along with higher spreads, uncertainty around regulations within various municipal sectors, and a rising interest rate environment may shift the interest of these investors to other fixed-income instruments or even to other asset classes.
Investors should keep a close eye on the yield & price valuations for their desired debt, credit ratings as they relate to certain issues, municipal issuers and different sectors as they can shed light on current and near-future financial health. Furthermore, almost all municipal issuers conduct various surveillance calls with their respective ratings agencies, and those surveillance reports can be quite informative in understanding the financial conditions of a municipality.
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