Unlocking Value in Laddered Munis

Geopolitical tensions, higher-for-longer interest rates, and a new Fed chair forthcoming. It seems like fixed income investors have plenty to worry about, but thankfully, they also have optionality when deciding where to allocate. An opportunity that warrants a closer look is the municipal bond market.

In a WisdomTree Office Hours session, Raising Awareness to Active Muni Strategies, Kevin Flanagan (head of investment & fixed income strategy at WisdomTree) and Jeffrey Burger (senior portfolio manager at Insight Investment) explored active, laddered bond strategies in the muni market. Furthermore, they explained how this makes for a compelling approach given today’s uncertain macroeconomic environment.

Key Takeaways:

• Taxable equivalent yields on high-quality municipal bonds are reaching 7% to 9%, offering a decade-high entry point that outpaces corporate high yield with far lower default risk.
• A uniquely steep municipal yield curve drives built-in price appreciation through the natural rolldown effect, while long-term secular factors favor a profitable flattening of the curve.
• Active laddered strategies like WTMU and WTMY capture alpha within specific maturity rungs by continuously replacing overvalued securities with cheaper, mispriced revenue bonds.

See more: WisdomTree’s Kevin Flanagan on How to Navigate Fixed Income

Decade-High Entry Point

If there’s a good time to get into munis, that time is now. With a rapidly changing macroeconomic environment and as Flanagan noted, a “10 year Treasury yields slowly hitting or going close to hitting 4.7%,” the fixed income playbook requires a new approach. For modern wealth managers, the combination of historically high nominal yields and unique structural tailwinds are turning municipal bonds into a compelling tool to generate alpha.

That said, the defining characteristic of today’s muni market are entry-point yields. Because munis are tax-free, their nominal yields look dramatically different when viewed through a tax-adjusted lens.

“The 30 year Treasury bond is at its highest since 2007,” Flanagan noted, citing “hotter than expected CPI, PPI numbers” and Middle East conflicts pressuring energy prices.

Burger emphasized that investors must calculate “the taxable equivalent yields you get promoting a municipal, because they are tax free.”

“Effectively, depending on the strategy, the treasury yields that we’re looking at, gross that up based on your applied or actual tax rate,” Burger explained further. “And you’re looking at yields in this environment, that I’m not really being hyperbolic. When I say, I haven’t seen in at least a decade, maybe longer, for high quality type credit. You’re looking at upward seven, eight, nine, percent type taxable equivalent yields. That’s pretty darn attractive on a nominal basis.”

Summarily those tax-adjusted yields are above the sub-7% yields currently found in the U.S. corporate high-yield index. However, munis offer an investment-grade risk profile and greater credit quality through its almost non-existent historical default probability.

“The entry point is nothing but compelling,” said Burger, speaking directly to medium- and long-term investors particularly.

Two Structural Tailwinds

Furthermore, there are structural tailwinds blowing in favor for munis in addition to summer seasonality. These include a remarkably steep yield curve and the potential for a medium-term macro flattening.

One of the big differences between munis and other markets right now “is how much incremental yield the investor receives from just extending a little bit.” Burger quantified this by stating that “the difference between a 10-year AAA maturity and a 30-year AAA bond is about two and a half times in terms of a steepness.”

“As that 30-year bond becomes a 29-year bond (and so on), there’s something called the rolldown effect,” Burger added. “As we go down that hill, the market has to compensate for the fact that the 30-year bond has become a 29-year bond. How does it do it? Price appreciation. That bond then becomes more valuable.”

Regarding the second tailwind, this refers to the broader economic setting. While oil spikes can apply pressure on near-term inflation, they “generally, over the medium term, lead to a slower economy, or a more efficient economy, i.e. lower inflation.” Combined with “the efficiencies and productivity increases from AI,” this macro shift is likely to cause “a flattening of our yield curve.” In turn, this directly benefits intermediate and intermediate-longer dated munis.

2 ETF Options: Active, Built-in Precision

To capitalize on the aforementioned dynamics, WisdomTree and Insight Investment partnered to launch two active, laddered municipal ETFs. The WisdomTree Core Laddered Municipal Fund (WTMU) focuses on investment-grade assets, while the WisdomTree High Income Laddered Municipal Fund (WTMY) captures excess yield in lieu of taking on greater credit risk. Unlike a passive ETF or an individual bond ladder strategy, these active ETFs use an institutional research-driven model to identify relative value.

“The real genius of the strategy here is it’s active within the maturity rungs,” Burger explained, noting that the research team behind both funds use a rigorous, fundamental bottom-up approach. “If we have a bond that is sitting in 2029 and we think it’s absolutely outperformed relative to its credit worthiness, we simply will sell that security and buy one that we think is cheaper, and generate a different yield profile that should absolutely generate excess returns in our opinion. What we’re trying to do is isolate alpha through credit.”

Originally published on Advisor Perspectives

For more news, information, and analysis, visit the Modern Alpha Content Hub.

Earn free CE credits and discover new strategies