Municipal-bond week in review: Yields on the upswing

NEW YORK, N.Y. – Municipal bond yields moved higher this week as investors digested a slew of reports on the health of the U.S. and global economy.

Earlier this week, China reported a drop in exports, but also a higher-than-expected rise in inflation, which traders took as a sign of strength for the world’s second-largest economy. On Friday, a report showing healthy U.S. retail sales offset weak consumer sentiment data. Altogether, the reports were consistent with investors’ expectation that the Federal Reserve would raise interest rates this year, putting downward pressure on bond prices.

Shares of the largest municipal exchange-traded fund, the iShares’ National Muni Bond ETF, fell nearly half a percentage point this week.

Bond yields, which move in the opposite direction to prices, rose accordingly. According to the AP Municipal Bond Index, the yield on the 10-year municipal bond was 2.020 per cent as of Friday at 5pm Eastern time, up from 1.978 per cent the previous week. It’s the first time the 10-year yield has breached the 2 per cent mark since April. The yield on the 2-year municipal bond, which has also been rising for the past month, finished the week at 0.945 per cent as of 5pm Friday.

Bonds that take longer to mature are riskier to hold, so they generally offer higher yields. The spread between 2 and 10 year muni bonds, which has been widening since its low of 0.994 per cent in the week following September’s Fed meeting, ended this week at 1.075 per cent.

In other muni bond news:

–Municipal money market funds adopt reforms

October 14th marked the deadline for short-term municipal funds to adopt reforms put into place after the 2008 financial crisis. Under the new rules, institutional money market and municipal funds, which cater to large corporate clients, must allow their share prices to fluctuate. The funds are also allowed to impose redemption fees.

The rules are intended to protect small investors in these short-term funds from extreme volatility in times of crisis, such as the massive run on money funds that took place in 2008 in the wake of Lehman Brothers’ bankruptcy.

For the past year, in anticipation of these reforms, institutional investors have exited money market and short-term municipal funds in droves. That’s sent prices on short-term munis down and yields up to the point where they nearly matched 2-year bonds, says Jon Mondillo, co-manager of the Alpine Ultra Short Municipal Income Fund, creating an opportunity for short-term muni investors to pick up some extra yield without taking additional risk.

The money fund exodus has also led to higher rates for municipal borrowers over the past few months. However, Fed officials believe that the overall impact on the financial markets is likely to be small, according to the minutes from a recent Federal Reserve meeting that were released this week. Most experts believe that with the reforms now fully in place, short-term munis and money funds will return to more normalized rates.