- For investors concerned about the prospect of rising interest rates, U.S. municipal bonds may be a good opportunity.
- U.S. municipal bonds can be a high quality, low volatility complement to an overall asset allocation.
- The potential diversification benefits of U.S. municipal bonds may enhance the overall risk-and-return profile of an investment portfolio.
This year, the U.S. Federal Reserve (Fed) is likely to raise interest rates at least two and perhaps as many as three times. The current rate hike cycle is the first in nearly a decade and after all those years of zero-bound rate policy, it may feel like a step into uncharted territory. Standish, however, has managed municipal-bond portfolios through many similar interest rate tightening cycles and our analysis of how various asset classes have performed during previous periods of rising rates makes us confident that opportunities will exist for investors to potentially earn attractive yields, while also reducing portfolio risk amid the ongoing normalization of monetary policy. We expect the current tightening cycle to be steady and gradual, likely playing out in a series of modest hikes until rates reach 3%.
MUNICIPAL BONDS DEFENSIVE BEHAVIOR DURING RISING RATES
While it’s generally true that there is an inverse relationship between interest rate movements and bond prices, investors should be aware that not all fixed income asset classes are created equal when it comes to the magnitude of price sensitivity to rate changes. At Standish, our research has shown that over the long term, municipal bond yields tend to exhibit lower volatility than Treasury yields. We have observed 10-year municipal bonds move approximately 60% as much as 10-year Treasuries (beta) over 3-year rolling periods.
As an example, assuming the historical 60% beta relationship holds, for a 100 basis point increase in 10-year Treasury yields, we would expect municipal bond yields to rise by about 60 basis points, translating to a price change of -4.9% versus Treasuries at -8.9%. While the beta experience in the future could vary from the historical average, it is reasonable to expect that the lower volatility characteristics of municipal bonds will help mitigate negative price effects of rising interest rates, particularly versus other liquid fixed income asset classes such as Treasuries.
The chart at left shows the defensive behavior of municipal bonds going back to 1990. In each highlighted period of rising rates, municipal bond total returns (pre-tax) were higher than comparable Treasuries. The magnitude of outperformance increases further when tax rates are considered. Volatility and beta are consistently lower in the municipal bond market than Treasuries over long and short time horizons.
HOW MUNICIPALS FARED DURING FED RATE HIKE REGIMES
Municipals have also demonstrated more defensive characteristics when the Fed has hiked rates markedly over a relatively short span. Muni yields tended to rise less than those of comparable Treasury securities as monetary policy turned from accommodative to restrictive. As seen in the chart below, covering the last two brief tightening regimes (January 1994 through February 1995, when the Federal Funds rate was raised by 300 basis points, and June 1999 through May 2000, when the rate was raised by 175 basis points), municipal yields exhibited considerably lower sensitivity to the Fed’s interest rate actions than did Treasury yields. The lower sensitivity to Fed rate hikes also increased out the yield curve, particularly at 10-year maturities and beyond.
WHY THE LOW MUNI BOND BETA?
Certain features of the municipal bond market help explain this observed defensiveness of municipals when the Fed is tightening. First, municipal bond valuations tend to respond to demand trends among individuals and households, who together own over two-thirds of all municipals, either directly or through funds. These investors often hold municipal bonds chiefly as a source of income and may step up their buying as rising interest rates create opportunities to lock in higher yields. The value from receiving tax-exempt income is typically greater for investors as lower-coupon bonds roll off and are replaced by higher-coupon bonds.
Supply conditions also support the defensiveness noted above. Often when rates rise sharply, issuers lose the ability to refinance existing debt by issuing refunding bonds. Choking off refunding activity can cut new issuance by as much as 30%, creating relative scarcity and tempering the price declines caused by rising interest rates.
SCARCITY OF HIGH QUALITY GLOBAL FIXED INCOME ASSETS
Municipal bond yields compare favorably to other high-quality sovereign bonds. A somewhat diminished supply of high-grade, AAA-rated sovereign and quasi-sovereign credits make municipals an attractive fixed income vehicle in view of relative yield and strong credit quality.
U.S. municipal bonds can be attractive to non-tax paying investors as a mechanism to increase risk-adjusted returns. Municipal bond returns have a low correlation with other asset classes, while delivering comparable levels of income versus similar quality-and-maturity global fixed income alternatives.
Fixed income bond investors may be able to cushion against future unrealized losses from rising interest rates by holding a core position in intermediate high-grade municipals. These bonds can potentially offer several positive characteristics, including attractive income, a lower volatility profile which contributes to diversification benefits, defensiveness against Fed rate hikes and high credit quality, all of which can help preserve investment income while further dampening the negative price impact of higher interest rates.