After years of giving investors heartburn, interest rate volatility has some lingering impacts. While the U.S. Federal Reserve cut rates three times in late 2024, it paused cuts in its January meeting and now anticipates only two cuts for 2025. With remaining cuts more meandering, likely to be deliberate and data-dependent, interest rates may remain elevated for a longer period. This would create an excellent opportunity for investors looking for income.
 

One group of income-seekers – municipal bond investors – has another consideration: The shape of the yield curve poses a problem for those who have relied on laddered strategies. A prolonged period of yield curve inversion – meaning shorter term interest rates were higher than longer term rates – turns the strategy of building a portfolio of bonds with increasing maturities and yields on its head. Even as the curve now just begins to normalize, it could be years before ladders’ value proposition makes sense again. Instead, an active approach to interest rate positioning that seeks to seize opportunities as the rates landscape evolves could benefit municipal bond investors.
 

Muni bond ladders: Popular, but potentially problematic
 

A muni bond ladder constitutes a portfolio of muni bonds of differing maturities, from shorter to longer. Upon maturity of the bond with the shortest life, the proceeds are typically reinvested in a new bond. That new bond becomes the longest maturity bond in the portfolio. This extends the ladder. The interest received from bond ladders is designed to be regular and predictable, and a ladder approach is easy to understand.
 

In a “normal” yield curve environment – when longer term bonds provide a term premium consisting of more yield than shorter term bonds – investors can benefit from the higher yields offered by the longer maturities. But we haven’t had a truly normal yield curve for some time. That means investors building ladders could be missing out on higher income potential.

In today’s environment, ladders may not climb as high
 

As 2025 begins to get underway, the muni yield curve has started to normalize but isn’t there yet: It remains largely inverted or flat. In this environment, ladders may not be ideal because long-term rates are not as attractive to investors, as they are not compensated for extension risk (e.g., extending the ladder with longer term investments). In fact, term premiums (the expected additional compensation for taking longer term risk) are very low versus a one-year muni investment. The term premiums are low compared to just a few years ago. Ladders anticipate that term premiums will increase as longer term bonds are purchased; however, adding that extension risk is not paying off today, as illustrated below.

While it’s anticipated the curve will eventually fully normalize, with long-term rates higher than short-term rates, no one can predict exactly when this will occur. Ladders are built with the assumption the curve is “upward-sloping” – in other words, the curve rises. Then, extending the ladder with fresh bonds purchased using proceeds from maturing bonds should deliver higher yields relative to simply buying short-term bonds. But in a downward-sloping or flat curve, that’s not always the case. This is referred to as “reinvestment risk.”
 

We believe there are three important considerations for investors in this environment: Duration, curve and diversification.
 

Duration management can provide an edge in a shifting interest rate environment
 

Duration represents interest rate risk; it’s the sensitivity of a bond to changes in interest rates. Bonds with longer durations are typically more sensitive to interest rate risk than shorter duration bonds. As noted, when the curve is normal (upward-sloping), investors are compensated for interest rate risk with higher yields. In a downward-sloping or flat yield curve, investors are not compensated for that risk. Bond ladders are “one and done” purchases, with no flexibility to address duration risk.
 

In contrast, active managers can help control, monitor and adjust duration depending on the investment opportunities and market environment in the portfolios they manage. They can also actively consider reinvestment risk timing. An actively managed portfolio may be modified to have more or less duration exposure. In a volatile interest rate environment like today’s, active managers may have opportunities to seek value in shifting interest rate expectations, unlike static ladder portfolios.
 

Rate volatility’s other opportunity: Active curve positioning
 

Curve positioning represents the opportunity to express conviction on how bonds with different maturity profiles might be impacted by rate volatility. Active management allows managers to pick and choose different maturities, unlike ladders, which do not have flexibility to pivot on curve exposure beyond the initial purchase.
 

Using 2024 as an example of a period with elevated interest rate volatility, the strongest returns across the muni curve often differed from month to month. This provided opportunities for managers whose research can help determine which parts of the curve look most promising at a given time. The table below shows indexes with different maturities reflecting different parts of the yield curve. Notice how the returns are continually shifting throughout the year: There’s no single maturity profile that consistently outpaced the others. 

Diversification: The third leg of the stool

Diversification among security selection serves an important purpose for a portfolio. With active management, a team of investment analysts, traders and portfolio managers can be incredibly beneficial. Teams can analyze bonds not only for information about the issues, but for valuation and the relative value between different bonds. Analysts can collaborate for a more holistic view of the market. Traders can offer insight on new issues pricing, secondary market activity, sector-specific developments and execution choices. Portfolio managers, along with the rest of the team, can study bond issues, talk to managers and perform onsite visits.
 

A final consideration: Cost
 

Cost is another factor. According to the Municipal Securities Rulemaking Board paper, Analysis of Primary vs. Recently Issued and Competitive vs. Negotiated Municipal Securities Markets, “individual investors often obtain a large portion of their bonds in the recently issued market and at higher prices than institutional investors.” Individual investors also paid higher spreads, as “smaller trade sizes had an average spread of just over $10.00 compared to less than $5.00 for larger-size trades.”
 

SMAs might be a solution for savvy investors
 

While active mutual funds and exchange-traded funds (ETFs) can provide these potential advantages, muni separately managed accounts (SMAs) could benefit investors looking for some customization. Muni SMAs are built with individual bonds that provide the same tax-sensitive treatment as muni bond ladders. They aim to provide current income exempt from federal tax. Investors own the individual bonds in their SMA – a notable distinction from a mutual fund or ETF. The active management in SMAs may reduce reinvestment risk relative to a laddered portfolio.
 

For example, as interest rate markets move amid policy uncertainty, active SMA managers can vary exposures across the entire yield curve, emphasizing or deemphasizing attractive/unattractive maturity profiles. This is differentiated from a ladder, which has a “locked in” position once purchased. Here’s a sample of a hypothetical ladder with four equal allocations to maturities ranging from 1–3 years to 7–10 years and actively managed SMA. Notice the flexibility of the SMA can take positions all across the yield curve.

Muni SMAs may also allow investors to select state specific, state preference or state best efforts, for income potentially exempt from state taxes. These investment vehicles may also offer a custom transition analysis/in-kind transitions and potential tax loss harvesting.
 

To learn more about the potential advantages of SMAs, visit here. For more detailed information about muni SMAs, visit Capital Group Short Municipal, Capital Group Intermediate Municipal or Capital Group Long Municipal. 

Investors should be aware of all their options in determining how to best achieve their goals. While muni bond ladders are available, there may be opportunity for investors to gain more yield, and thus more income, with other investment vehicles. Unlike bond ladders, muni SMAs may consider not only security selection, but duration and curve positioning to build portfolios, all with a team of highly trained analysts, traders and managers seeking opportunities in this tax-sensitive market. Investors may want to consider muni SMAs in the current environment of interest rate volatility.