With contributions from Daniel Sarnowski, Portfolio Specialist, WFAM Global Fixed Income
We are now in a period of rising interest rates, and investors may wonder how municipal bonds have fared in past periods of rising rates and if they have a place within an asset allocation plan today. The answer is that, historically, municipal bonds have performed well when interest rates are increasing.
In the past 35 years:
- The Federal Reserve (Fed) undertook six rate-hiking cycles.
- The yield on the 5-year U.S. Treasury rose more than 125 basis points (bps) eight times.
- The total return of the Bloomberg Barclays Municipal Bond Index adjusted for taxes was positive seven of the eight times that intermediate-term rates rose.
- Each time, municipal bonds on a tax-adjusted basis outperformed the broader taxable U.S. bond market.
Municipal bonds have done well amid rising interest rates for a number of reasons. They are less correlated to U.S. Treasury bonds than taxable bonds issued by corporations and therefore have less interest rate sensitivity. The municipal market is less efficient than many other markets, allowing active managers to find relative value opportunities as they exploit pricing discrepancies. In addition, the sector has exhibited less volatility than other fixed-income sectors, largely due to its base of retail investors that invest in buy-and-hold strategies focused on income.
Income is another important part of the reason that municipals have done well. Income, the interest earned from coupon payments, historically has been the main portion of a bond portfolio’s total return. To recap, there are two elements to total return: price return and income. As interest rates rise, bond prices fall and result in negative price returns. However, total returns may still be positive because the income, over time, tends to more than offset the price declines. In a rising rate environment, income earned is reinvested at higher rates, which in turn leads to an even higher level of income and adds to total return.
Three reasons municipal bonds have outperformed taxable bonds
1. Lower correlations to U.S. Treasuries aid municipal bonds. Municipal bonds, like corporate bonds and the broader U.S. bond market, are interest rate sensitive and have positive correlations to the U.S. Treasury market. Because the correlation is lower, the relationship is less significant. As Treasury yields move, municipal bonds tend to move in the same direction but to a lesser degree, which means they are less interest rate sensitive.
2. An inefficient market also provides an edge for municipal investors and offers fertile ground for active managers to exploit. According to the Federal Reserve, the Municipal Securities .Rulemaking Board, and the NYSE/NASDAQ as of the first quarter 2018, the $3.8 trillion municipal market contained about 1 million individual CUSIPs. For comparison, the corporate bond market had only about 20% as many individual CUSIPs and the equity market had only 10% as many. As a result, there is less coverage from sell-side credit analysts in the municipal bond market and less information about individual credits or issues.
Further, trading in the municipal bond market is distinct from other bond markets because it does not have dominant, standardized, electronic trading platforms such as those for the taxable corporate bond and U.S. Treasury bond markets. Instead, trading in the municipal market is done over the counter (directly between two parties rather than through an exchange), and a trader’s relationship with counterparties often affects his or her ability to buy or sell securities when needed. Timing is different than in the corporate bond market, too. For example, trades are required to be reported within 15 minutes instead of nearly instantly, as happens in the corporate market. As a result, muni price discovery tends to be more opaque than in other markets. As we have said in the past, the large and inefficient aspect of the muni markets may leave active managers considerable relative value opportunities.
3. The municipal bond market tends to be less volatile than the taxable bond market due to its large base of investors with a longer-term investment horizon rather than a trading mentality. More than 43% of the muni market is held by households or in private pensions and government retirement plans. Mutual funds, money market funds, closed-end funds, and exchange-traded funds account for an additional 25% of municipal bond holders. Insurance companies, which may hold muni bonds for diversification benefits and book yields, may be less motivated to sell bonds quickly in the face of rising yields, and they account for 13% of the market.
Five muni strategies to consider when rates rise
As investors look for ways to create a successful investment outcome for themselves, a number of investment strategies may be used to manage the effect of higher rates. The common thread among these strategies is that they seek to limit downside price effects and add income to bolster total returns.
Investors may also benefit by recognizing that certain patterns have historically happened during periods of rising rates. For example, the yield curve has flattened, credit (intermediate-quality and lower-quality bonds) has outperformed higher-quality bonds, and bonds with above-market coupons (also known as premium bonds) have outperformed lower-coupon bonds. With these patterns in mind, particular yield curve strategies, credit-quality allocations, and issue selection decisions may be made that have historically done well in such environments.
- Duration. Flexible duration strategies may be used in an effort to manage interest rate risk. Because duration measures a portfolio’s sensitivity to interest rate changes, a shorter duration relative to a respective benchmark, by definition, reduces a portfolio’s volatility (price declines) due to increases in interest rates. Investors may want to consider active management for its ability to adjust to different interest rate scenarios as well as flexible strategies that have a wider spectrum of duration.
- Yield curve allocation. One way to take advantage of a yield curve that is flattening (the difference between long-term and short-term rates shrinks) is by using a barbell structure, which means overweighting specific maturity ranges within a portfolio’s maturity limits. In addition, intermediate- and longer-term investors often have experienced positive total returns while the Fed has been hiking due to the passage of time (rolling down the yield curve faster than the rise in Treasury spot rates) and to the receipt and reinvestment of interest, which can help offset capital losses.
- Credit exposure. Based on history, asset classes with more income from lower-credit-quality bonds (rather than duration exposure) have the potential for additional income, which can help offset price declines in a portfolio in a rising rate environment. These types of bonds have the potential for their price to maintain value or increase in a rising rate environment as the economy improves and credit spreads tighten, further adding to total return.
- Sector and issue selection. Owning the right bonds as rates rise is a key factor for success. Rigorous credit analysis is required in order to identify credit opportunities and pitfalls in a rising rate environment. In addition to correctly assessing a bond’s creditworthiness, the structure of a bond is important. Positioning into premium coupon bonds, which are defensive in nature, tend to outperform lower-coupon bonds in rising rate environments.
- Liquidity. Maintaining adequate liquidity and cash levels is important to capitalize on expected opportunities in credit, yield curve positioning, and relative value trading.