As Interest Rates Rise, Muni Bonds Offer a Unique Opportunity to Investors
The Federal Reserve Board (the “Fed”) is expected to raise short-term interest rates several more times this year. As the Fed tightens monetary policy, investors’ concerns about their municipal bond investments may also be on the rise. Importantly, our seasoned Municipal Bond team has a history of managing portfolios through similar cycles. Historical analysis of municipal bond behavior relative to U.S. Treasuries in rising rate environments points to potential opportunity for attractive tax-exempt yields without the volatility commonly associated with Treasuries.
Muni Bond Behavior During Previous Rate Hike Cycles
Municipal bonds have delivered higher returns and lower volatility than Treasuries of comparable maturities during the three most recent periods of rising rates. Between January 1994 and February 1995, the federal funds rate rose 300 basis points (bps). The Fed raised rates by 175 bps from June 1999 through May 2000 and again by 425 bps, in a series of 17 rate hikes of 25 bps each, between June 2004 and June 2006. We expect the current tightening cycle will be steady and gradual, likely resulting in four hikes in 2018 and two or three hikes in 2019 until rates reach 3% to 3.25%.
Bloomberg Barclays Municipal Bond Index Returns as U.S. Fed Tightens Monetary Policy
During each of those prior periods, municipal bond yields fluctuated less than Treasury yields. Our research shows that over 3-year rolling periods, yields on 10-year municipal bonds exhibited only 65% of the volatility seen in 10-year Treasuries. Using history as a guide, a 100-basis-point rise in 10-year Treasury yields would likely be accompanied by a 65-basis-point rise in municipal bond yields. While future yield changes could deviate from historical averages, we expect muni bonds with 10-year maturities or longer to show significantly less volatility than 10-year Treasuries.
Munis Have Outperformed Treasuries When Rates Rise
Munis Are Attractive in a Rising Rate Environment
The relative price stability of municipal bond prices is a function of the unique intrinsic characteristics of the bonds themselves and their investor base. Although a number of factors affect municipal security valuations, an important aspect is the consistent level of demand from individual investors, who own more than two-thirds of the entire municipal bond market directly or through mutual funds. Municipal bonds also experience lower price volatility because investors tend to favor the asset class’s tax-exempt income and hold bonds to maturity. Investors’ buy-and-hold mentality reduces concern about the impact of rising and falling markets. As rates increase, the tax-exempt income that municipal bonds offer becomes more attractive, and many investors begin attempting to derive more of their total return from coupon income. As a result, the high level of tax-exempt income that muni bonds offer becomes more attractive as rates rise.
New issue volumes also affect the defensive characteristics of municipal bonds in rising interest rate environments. As one might expect, higher borrowing costs typically reduce new issue supply as state and local governments curtail debt issuance at higher interest costs. The subsequent supply-and-demand imbalance can result in a relative scarcity, which helps temper price declines caused by rising interest rates.
For fixed income bond investors, a core position in intermediate high grade municipal bonds may help cushion the prospects of unrealized losses from rising interest rates. These bonds can offer several positive characteristics, including attractive income, a lower volatility profile, diversification benefits, high credit quality, and a defense against Federal Reserve rate hikes. All of these characteristics can help preserve investment income while dampening the negative price impact of higher interest rates.