Although Federal Reserve (Fed) officials voted to keep their benchmark borrowing rate unchanged at the June Federal Open Marketing Committee (FOMC) meeting, it seems that a prolonged pause in the rate-hiking campaign isn't on the horizon. Surprising investors, policymakers indicated the possibility of two more rate hikes in 2023.
It’s uncertain times like these when Riverbend's proactive approach to portfolio management truly shines. We take a defensive approach by structuring municipal bond portfolios with reasonable duration and focusing on high-grade credit. We identify bonds that align with clients’ income and safety objectives with the goal of mitigating risks present in other parts of their investment portfolios.
We stand by this proactive approach, but we also recognize the importance of incorporating an offensive element when market dynamics shift and new opportunities arise. The current situation, with the inversion between the 3-month and 10-year Treasury yields, is a prime example of such a time.
Uncommon Dynamics Call for an Adaptive Strategy
An inverted yield curve, where shorter-term U.S. government-issued bonds yield higher interest rates compared to longer-term bonds, is a relatively uncommon occurrence. Normally, investors anticipate higher yields for longer investment durations. However, in 2022, as the Fed hiked rates in an attempt to rein in inflation, we witnessed the emergence of an inverted yield curve that has carried into 2023.
Balancing Flexibility and Yield
We’ve adapted to the current yield curve environment by investing capital in munis at both the short end—typically 18 months or less—and at the long end—10 years or more. This barbell approach seeks to take advantage of multiple market opportunities.
On the shorter end of the spectrum, the inclusion of short-term muni bonds provides attractive yields. These bonds serve as a reliable, consistent income source with low duration. The longer-term bonds maximize yield curve steepness in that range where there are significant incremental increases in yield for each additional year of duration. This allows investors to secure equity-like returns on high-quality bonds with predictable income streams.
"The inclusion of short-term muni bonds provides attractive yields. These bonds serve as a reliable, consistent income source with low duration."
This barbell structure is particularly appealing to investors with longer investment horizons who prioritize stable income and the preservation of capital. By diversifying their portfolios with muni bonds of varying maturities, these investors can benefit from both short-term yields and the potential for higher returns associated with longer-term bonds.
As the shorter bonds in their portfolios reach maturity, investors have the flexibility to roll the proceeds into more short-term bonds, move out to intermediate or longer duration, or reallocate to alternative investment options in response to changing market conditions. This adaptability enables investors to navigate evolving circumstances while maintaining a reasonable overall duration for their portfolios.
Additionally, the barbell approach allows investors to take advantage of the steep yield curve prevalent in longer-term bonds. By capitalizing on the higher yields available on the long end of the curve, investors can potentially optimize their returns while adhering to a prudent investment strategy.
Inflection Points and Adaptability
We believe our barbell approach is a suitable strategy given current market conditions. However, we remain vigilant in identifying potential inflection points that might necessitate a strategic shift. These points include scenarios such as declining interest rates, a general flattening of the yield curve, or increased attractiveness in intermediate-duration municipal bonds. With our experience in the municipal bond market, we've learned that the only thing you can predict with any certainty is that market conditions will inevitably change. We've also learned that disorder and the subsequent opportunities it creates can bode well for municipal bond investors looking to put cash to work.
Call us to find out about the opportunities we’re currently seeing in the muni bond market and to learn about how we help advisors optimize clients’ municipal bond strategies.
