My colleague Bill O’Neill wrote a piece the other week about the extending durations of both the corporate and Treasury markets. In essence, lower rates and lower coupons, all else equal, result in longer duration bonds in these mostly optionless markets. After reading his comments, it got me itching to write about a market where we are going in the opposite direction, despite the same interest rate scenario. The tax-exempt muni market has been shortening in duration (option adjusted) over the past score of years. This highlights the differences in convexity between these two markets – a smiling (happy), positively convex corporate/Treasury market, and a frowning (sad), negatively convex muni market. This negative convexity is the product of the large amount of callable bonds in the muni market. The level of duration divergence is quite amazing. Corporates have extended from 6.35 years at the beginning of 2010 to 8.72 years today – a 37% extension in duration. Munis have gone from 8.28 years to 5.34 years over the same time period – a 36% reduction in duration.
Callable munis typically don’t exhibit excess returns in the textbook-defined shape of negative convexity – an upside-down “U”, a “sad” frown for some, or y=-x^2 for others. Most curriculum-based explanations of callables and negatively convex structures focus on at-the-money options, and fail to account for the deep-in-the-money nature of callable options in the muni market that are the product of premium pricing. Instead, these excess return calculations are better measured against the opportunity cost associated with a more stable, bulleted structure. We’ll explore the intricacies of callable muni valuations in a future posting (hopefully, you will share my excitement in the topic). For now, we’ll discuss some of the oft-not considered potential portfolio ramifications of diverging durations.
While many conversations revolve around nominal positioning, internal portfolio conversations more often reflect durations and contributions thereof. This convexity dichotomy can have an interesting effect on portfolio positioning, especially in a Crossover Strategy. An ever-shortening muni market, combined with an ever-extending corporate market, results in unique shifts – both nominally and in terms of contributions to duration. Imagine you created a 50/50 blend of the muni and corporate markets at the beginning of the last decade. You would have a portfolio duration of 7.32 years, with 57% of the duration coming from munis. That same 50/50 blend today would have a slightly shorter duration at 7.03 years, but the muni component’s duration contribution would have fallen from the 57% noted above to 38% today. This brings up an interesting thought process. If you had a passively invested 50/50 blend as noted above, given historically higher default rates and volatility in corporates compared to munis, even with relatively frequent rebalancing, your passive portfolio today would be more risk-on than what you created just over a decade ago. We believe this introduces two important factors: the benefits of active bond management and being benchmark aware, but not beholden. Both factors, along with communicating with our clients, help us manage passive increases in risk over time.
In our opinion, divergence creates opportunities, whether it be diverging durations, correlations, returns, liquidity, or any other factor. One unique difference in duration divergence versus that of returns is it doesn’t necessarily oscillate or mean revert, and thus requires a very long-term view of the portfolio, as these relationships can continue to move apart for another decade or more depending on the interest rate environment. Maturity preferences of issuers and investors will also have an impact on market durations, and could offset convexity-related duration drifts or exacerbate them. We’ll continue to monitor these moves, along with all other dynamics of the fixed income markets, and, as always, seek to take advantage of the potential dislocations these divergences create.
