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Market View

History reveals that the muni market has held up well during periods of well-communicated, gradual rate increases by the U.S. Federal Reserve.

In the January 30, 2017, Market View, we noted that municipal bonds were off to a good start for the year, after a challenging market environment at the end of 2016.  The fourth quarter of 2016 was marked by a rapid rise in U.S. Treasury bond yields, uncertainty about changes to the U.S. tax code under a new political administration, and large outflows from municipal-bond mutual funds.  After $28 billion in net outflows from municipal funds in the last two months of the year (based on Morningstar data), the market began to stabilize as 2017 began. 

Amid the volatility, the representative Bloomberg Barclays Municipal Bond Index actually finished the first quarter of 2017 with a positive return of 1.6%.  At first glance, that might seem like a modestly positive showing, but that number looks more compelling when that tax-exempt return is compared, respectively, to the returns of 0.7% and 0.8% by two other Bloomberg Barclays taxable bond benchmarks: the U.S. Treasury and U.S. Aggregate Bond indexes. 

This positive performance by municipals followed a 1.2% return in the month of December 2016. This period also coincided with two 25 basis-point rate hikes by the U.S. Federal Reserve (Fed)—one in December 2016 and another in March 2017.  And the Fed remains much on the minds of muni investors. One common question we are asked is, how will municipal bonds fare in the face of continued rate hikes by the Fed, especially with policymakers’ expectation of a total of three rate increases in 2017?

We’ll tackle that question in this Market View. First, some historical perspective is in order.  Begin with a look at Chart 1, which shows return data for the broad municipal bond market (as represented by the Bloomberg Barclays Municipal Bond Index) over the past 30 years:

 

Chart 1. Fed or No Fed, Negative Years Have Been Rare for Municipal Bonds
Calendar-year returns of the Bloomberg Barclays Municipal Bond Index, 1987–2016

Source: Morningstar.  Shaded areas represent periods during which the U.S. Federal Reserve raised interest rates.
Past performance is not a reliable indicator or guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future. Other time periods may have been different. The historical data are for illustrative purposes only and do not represent the performance of any portfolio managed by Lord Abbett or any particular investment.

 

We note four key takeaways from the chart:

  • Municipals have generated positive returns in 26 of the past 30 calendar years.
  • Each negative year was followed by a strong recovery in the following year: 1995, 17.5%; 2000, 11.7%, 2009, 12.9%, and 2014, 9.1%.
  • Only two of these negative years—1994 and 1999—coincided with a period of the Fed raising rates.
  • Municipals generated positive returns in the last extended period of Fed hikes, during 2004–06.

There is, however, one other important point not reflected in the chart: short-maturity municipals (as represented by the Bloomberg Barclays Municipal Bond 3 Year Index) have generated positive returns in all 25 calendar years since index inception in 1991, based on data from Morningstar.

A Tale of Two Cycles
To be sure, not all Fed-tightening cycles are the same.  To illustrate this point, let’s take a look at the environment in two periods of significant Fed rate-hike activity, those beginning in 1994 and 2004, respectively.

1994: An Aggressive, and Less-Than-Transparent, Fed

The Fed raised its overnight target rate by 300 basis points (bps) over a 12-month period beginning in February 1994.  Not only did the central bank move in 25 bps increments, as it commonly does today, but this cycle also included three moves of 50 bps each, and one 75 basis-point rate hike in November 1994. 

During this aggressive period of tightening to squelch inflationary pressures, the Fed was much less transparent about its intentions. This resulted in a good deal of volatility in the fixed-income market, and in higher yields on longer-duration U.S. Treasury securities.  For example, the yield on the10-year U.S. Treasury note rose, from a low of 5.2% in late 1993 to peak at 8.0% in late 1994.  This big move in longer-term yields led to negative returns across U.S. fixed-income markets.

This move to higher rates also led to a 5.2% decline in the broad Bloomberg Barclays Municipal Bond Index (see Table 1).  But short-maturity munis, given their lower duration, were still able to generate modestly positive returns of 0.7%.  In addition, municipals outperformed comparable-maturity Treasuries, as the 10-year muni index declined by 4.8%, outperforming the 8.3% loss suffered by 10-year Treasuries.

 

Table 1. In 1995, Munis Rebounded Sharply after a Period of Aggressive Fed Hikes
Total return by index for the indicated years

Source: Morningstar. 
Past performance is not a reliable indicator or guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future. Other time periods may have been different. The historical data are for illustrative purposes only and do not represent the performance of any portfolio managed by Lord Abbett or any particular investment.

 

Finally, it’s worth taking another look at Chart 1, which shows that 1994, the worst calendar year for muni bonds during the 1986–2016 period, was followed by the best year, in 1995, with a 17.5% return.

2004: A Gradual, Transparent Fed

In 2004, the Fed took a very different approach, and took pains to indicate its intention to raise rates in a slow and gradual manner.  Over a two-year period, the central bank raised rates 17 times, each time by 25 bps, for a total policy tightening of 425 bps.  Since this was clearly communicated, it was much less disruptive to the market.

Despite a 425 basis-point move in the fed funds target rate, the move in longer-maturity debt was contained.  For example, between June 2004 and June 2006, the yield on the 10-year U.S. Treasury note rose by approximately 50 bps, from 4.7% to 5.2%, before retreating to 4.7% by the end of 2006.

As Table 2 shows, the broad municipal market generated positive returns in each of the years 2004–06, while outperforming the taxable Bloomberg Barclays U.S. Aggregate Bond Index (and that’s even before considering the tax advantage offered by municipals).  To the surprise of many investors, longer-maturity bonds outperformed short- and intermediate-term maturities over this three-year period. Investors who tried to time the market by going to cash or focusing on the shortest maturities in anticipation of Fed hikes, however, missed out on the best returns in the municipal market.

 

Table 2. In 2004-06, Munis Stayed Positive in a Period of Gradual, Well-Communicated Fed Hikes
Total return by index for the indicated years

Source: Morningstar.
Past performance is not a reliable indicator or guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future. Other time periods may have been different. The historical data are for illustrative purposes only and do not represent the performance of any portfolio managed by Lord Abbett or any particular investment.

 

What about Now?
So, what should investors in April 2017 do with their municipal portfolios in anticipation of further rate hikes by the Fed?  First, we would suggest that they avoid making any big moves based on expectations of future interest-rate movements.  History has shown that the timing and magnitude of rate moves have been very difficult to predict with any consistency. 

While history does not always repeat itself in the same manner, we would ask investors if they truly think that, in the coming months, the Fed may act as it did in 1994, surprising the market with aggressive rate moves in order to fend off a spike in inflation.  Or, is it more likely that the Fed will take a slow and gradual approach, clearly articulating its policy intentions to the market, so as not to startle it? One factor to consider in this regard is the detailed “dot plot” summary of rate-hike expectations issued periodically by Fed policymakers. The March 2017 dot plot indicated a less aggressive pace of Fed tightening than the market had feared.

In the current U.S. economic environment marked by moderate growth and inflation, longer-maturity municipal bonds provide high tax-free income and can still perform well in the face of a slow and gradual rise in short-term rates.  However, if you believe that higher inflation will lead to a sharp increase in long-term rates, then shorter maturities may offer a measure of protection for your portfolio. 

Muni investors may wish to consider a few options based on the above scenarios. One approach would be to build a “barbell” portfolio of longer-maturity bonds paired with short-maturity bonds.  Or, as we highlighted in the March 6, 2017, Market View, build a managed ladder muni-bond portfolio that can actually benefit from rising rates.

Employing such a structure when rates are rising means that as the constituent bonds of the ladder mature, they are reinvested at higher, prevailing market rates. The addition of higher-coupon “rungs” to the ladder results in a higher income stream for the investor.

In the case of a stronger U.S. economy, adding high-yield municipal bonds may be appropriate as well.  Lower-rated issuers tend to be more economically sensitive, and so can see improved credit profiles in a strengthening economy.  In fact, over the past 10 years, the high-yield municipal market has had zero correlation with the U.S. Treasury index, suggesting that high-yield munis will not follow the path of Treasuries. So, not only does the asset class offer the potential for higher income but it also can provide an effective means of diversification to an investment portfolio.

Summing Up
A common refrain in financial media is that “when interest rates go up, bond prices go down.” But as we’ve noted before, when confronted with generalizations, investors should ask for specifics:  Which rates are going up? Which categories of bonds are we talking about?  As we have illustrated many times in the past, not all segments of the bond market move in lockstep. And based on our analysis of the past few decades in the muni market, we offer three concluding thoughts:

  • Exiting muni bonds based on a bet on future interest rates has not proven to be a sound strategy.
  • Instead of trying to time the muni market, investors have been better served by staying invested over the long term.
  • Investors may wish to consider whether their muni allocations are appropriate for the current environment. The availability of professionally managed municipal bond strategies may prove helpful in this regard.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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