After years of zero-bound rate policy, possible interest-rate hikes are in the forecast this year. Because the current rate-hike cycle is the first in nearly a decade, it’s understandable that many investors feel like they’re entering uncharted territory.
It’s anticipated that the tightening cycle will be gradual and modest until a 3% rate is reached. Since the market has been aware of the rate hikes for some time, they should not cause alarm. As expected, rising interest rates are generating greater interest in—and greater need for—tax-efficient investment options among investors.
This is where U.S. municipal (muni) bond mutual funds can play a vital role in potentially minimizing volatility within investors’ portfolios. Munis may help defend a portfolio against Fededral Reserve rate hikes, preserve investment income seek to dampen the negative price impact of higher interest rates. Now may be the time to learn more about the multiple characteristics of munis.
How Trump’s Tax Proposals Could Affect the Municipal-Bond Market
The Trump administration’s tax proposal, which calls for lowering the corporate tax rate to 15% from 35%, as well as dropping the top marginal federal rate to 35% from 39.6%, has been greeted with indifference by the municipal-bond market thus far. Both the municipal- and Treasury-bond markets have taken the announcement in stride with rates and ratios changing only slightly.
We assign a low probability to the passing of a corporate tax-rate reduction to 15% and markets seem to agree. The administration’s proposed tax-reform package and market impact bears watching closely, however, as it winds its way through the legislative process.
Perhaps the most impactful part of the plan calls for lowering the corporate tax rate to 15%. This proposed cut in the corporate rate is significant as the lower tax rate would reduce the appeal of tax-exempt bonds for the insurance companies and banks that hold 14% and 15% of outstanding municipal debt, respectively.
Standish believes that while demand from these institutions could decrease gradually as a result of this lower tax rate, widespread selling is unlikely. Accounting conventions should keep insurance companies from rapidly selling off municipal bonds and the favorable risk/reward and liquidity characteristics of these bonds continue to make them attractive investment propositions.
Other provisions of the Trump tax proposal offer even less chance of disrupting the municipal-bond market. A proposed cut in the top individual income-tax rate from 39.6% to 35% would likely have a negligible impact. Previous cuts to top marginal rates, such as those enacted during the Ronald Reagan and George W. Bush administrations, had no discernible impact on municipal-bond pricing; also, historically, municipal-bond yields have consistently been higher than the prevailing implied tax rate relative to Treasuries.
As Interest Rates Increase, the Appeal of Munis Can also Rise
The key reason is the tax-exempt income that munis offer may become more attractive to investors as rates increase. A brief overview of munis may be helpful:
- They offer a potential source of income that’s free from national, and sometimes state and local, income taxes.
- This enables investors to pursue potentially higher current income on an after-tax basis without being exposed to risks that may accompany higher-yielding, non-investment-grade options.
- When interest rates rise, investors may tend to step up their purchasing of munis to lock in higher yields, which can increase their appeal.
Because investors have historically tended to hold muni bonds to maturity, there may be fewer munis available precisely when more investors are finding them attractive. This is where muni funds can become a compelling option for investors seeking the benefits of munis without purchasing individual muni securities.
The Relative Steadiness of Munis Is Unique
Collectively, individuals and households own over two-thirds of all muni bonds directly or through funds.
This means muni bonds’ valuations have typically responded to demand among these groups. Because both individuals and households have tended to stick with muni investments, rising interest rates may pose less of a threat for those who hold muni bonds to maturity. As a result:
- Changing rates and yields may not affect an investor’s total return.
- Investors receive regular interest income as well as the value of the bond at maturity.
This illuminates an important perspective for investors to consider:
- Rising rates may offer investors the opportunity to reinvest the income their bonds yield into newly issued, higher-yielding bonds.
Fixed Income Expertise When It’s Needed Most
Dreyfus offers an extensive selection of municipal bond funds, managed by an affiliated subadviser, Standish Mellon Asset Management Company LLC (Standish), an established firm dedicated to serving sophisticated fixed income investors. Significantly, the investment strategies Standish offers span both taxable and muni fixed income disciplines. Standish stands out due to its:
- History that dates back to 1933.
- Experience in managing municipal bond portfolios through many interest-rate cycles.
Active management gives the Standish portfolio managers the ability to address rising interest rates as they unfold — and this can help minimize volatility in an investor’s overall portfolio.
For example, Standish research shows that over 3-year rolling periods, yields on 10-year municipal bonds have historically exhibited only 60% as much volatility as 10-year Treasuries. Standish expects muni bonds with longer maturities, particularly those greater than 10 years, to show significantly less volatility than 10-year Treasuries. We believe this represents a timely opportunity and could enhance investors’ confidence in a rising interest-rate environment, particularly those who feel they are entering an unfamiliar reality of higher rates.
An Array of Options to Meet Investors' Needs
Based on your goals and risk tolerance, among other factors, Dreyfus may have a solution to meet your unique needs and objectives.
In addition to mutual funds, Dreyfus offers separately managed accounts in a range of asset classes and investment styles, all managed by professional asset managers. Learn about the Dreyfus Managed Asset ProgramSM (DMAP), and Standish, the portfolio manager for the DMAP Municipal Bond series separately managed accounts. With a DMAP Municipal Bond Series separate account, an investment option under the Dreyfus Managed Asset Program, a wrap-fee, investment advisory program, you own the individual bonds in your portfolio. Standish’s tax-sensitive team uses its expertise to construct laddered portfolios across a 10-year range that seek to help you manage interest-rate risk. These ladders represent a conservative approach, with all bonds rated AA- or better. If Standish determines that, because of credit deterioration, a bond in the portfolio may see its rating fall below AA-, a sale of the bond will be recommended. Wherever possible, in these situations Standish seeks to sell prior to the rating agency downgrade.