Are Your Muni Portfolios Prepared for Rising Rates?
MacKay Municipal Managers believes that prudent, active managers can continue to extract returns from the municipal market, even in a rising interest-rate environment. In our opinion, characteristics unique to the municipal market actually need rising rates, or at least the conditions that are conducive to rising rates, to produce investment opportunities. In addition, we believe that an actively managed, relative-value driven approach seeking to generate total return in the municipal bond market is not limited by the direction of rates and, in our view, can benefit from market environments where volatility increases.
At MacKay Municipal Managers, we have been cautious about the potential for rising rates for some time now. As a result, we have been long-prepared to navigate this, as we have built and actively managed portfolios. However, we continue to manage portfolios with a “duration neutral” target, based on their benchmarks. We do not actively change portfolio durations in anticipation of short-term rate movements because we believe this is an ineffective way to potentially generate superior investment returns.
When we think about the potential for rising rates today, we believe the following:
1. That we will likely see rates increase at a gradual pace over time. Therefore, income to be earned is an important component of estimating expected total return, much like we saw between 2004 and 2006.
Breaking Down Return Components Across the Municipal Market (Cumulative Returns: June 2004 – June 2006)
Source: Barclays, as of 5/31/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Barclays Capital 1-5 Year Municipal Bond Index measures the performance of municipal bonds with time to maturity of more than one year and less than five years. Bloomberg Barclays Municipal Intermediate (5-10 Year) Bond Index: Is an unmanaged index of long-term, fixed-rate, investment-grade, tax-exempt bonds representative of the municipal bond market. The Bloomberg Barclays 5-Year Municipal Bond Index is the 5-year (4-6) component of the Bloomberg Barclays Municipal Bond Index. Bloomberg Barclays 7-Year Municipal Bond Index is an unmanaged index of municipal bonds issued after January 1, 1991 with a minimum credit rating of at least Baa, been issued as part of a deal of at lest $50 million, have a maturity value of at least $5 million and a maturity range of 4-6 years. As of January 1996, the index also includes zero coupon bonds and bonds subject to the Alternative Minimum with maturities between nine and twelve years. The Bloomberg Barclays 10-Year Municipal Bond Index is the 10-Year total return subset of the Bloomberg Barclays Municipal Bond Index.Barclays Capital Long-Term Municipal Bond Index is composed of those securities included in the Barclays Captial Municipal Bond Index that have maturities greater than 22 years.The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment-grade tax-exempt bonds with a maturity of at least one year. Bonds subject to the alternative minimum tax or with floating or zero coupons are excluded. Barclays Municipal High Yield Index is an unmanaged index consisting of non-investment grade, unrated or below Ba1 bonds.
2. We believe that municipal bond yields will follow their historic pattern of rising less than yields on comparable maturity Treasury bonds. As a result, we expect a more tempered impact in the municipal market.
3. We believe that shorter-term yields should rise more than longer-term yields, leading to a flatter municipal yield curve. We have positioned our clients’ accounts to specifically avoid the four- to 10-year segment of the municipal market because we believe it will underperform in a flattening yield curve environment. Recently, we have favored bonds maturing between 10 and 25 years.
4. We expect that owning premium coupon, callable bonds in the 10- to 25-year segment of the curve will provide a further cushion, in the shorter run, against unexpected upward spikes in rates.
5. In addition, we continue to view credit spreads for medium-to-lower investment-grade bonds to be attractive because we expect them to tighten over time as credit fundamentals improve with economic growth. As a result, we have maintained overweight exposures to credit because we expect those bonds to show a lesser degree of sensitivity to upward rate movement. In addition, we believe that credit spread tightening will further mitigate the negative impact of rising rates.
High-Yield Municipal Spread
Source: Bloomberg, as of 5/31/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment-grade tax-exempt bonds with a maturity of at least one year. Bonds subject to the alternative minimum tax or with floating or zero coupons are excluded. Barclays Municipal High Yield Index is an unmanaged index consisting of non-investment grade, unrated or below Ba1 bonds.
6. For those clients with investment guidelines that allow interest-rate hedging, we use interest-rate hedges to keep portfolio durations in line with benchmarks, even as we overweight exposure to the 10- to 25-year segment of the yield curve.
7. At this inflection point in the direction of interest rates, we expect market uncertainty to rise, and therefore, result in more periods of volatility. We believe that this volatility further enhances our ability to identify mispriced security opportunities in the market and generate additional alpha.
8. We look for very short maturity bonds that are out of favor with the market, and therefore, priced very cheaply. These can allow us to maintain our targeted income accrual rate, while building in some natural reinvestment activity over the next two to three years, hopefully at higher yields, without taking on price risk.
9. We also, to a very limited extent, use floating rate notes with coupons that reset higher, as rates rise. Our expectation is that these instruments also provide a form of rate hedge, as prices stay close to par, while income rises.
10. We find opportunities to exploit the difference between institutional and individual (retail) markets on an almost daily basis. For example, we can buy bonds wrapped by newer bond insurers at very cheap institutional levels because institutions generally assign minimal value to the insurance policy. However, individual investors lack the ability to conduct credit research, and therefore, generally assign a much higher value to the same insured bonds. We engage in that trade virtually every trading day, regardless of the direction of rates.
11. Since our arrival at MacKay in 2009, we have focused on buying bonds, when all other conditions are equal, that have the opportunity to be advance refunded. Our objective was to build up holdings in securities that would, when rates rose, become advance refunded and produce positive price returns.
Fixed-income instruments are not all created equal, in terms of their interest-rate sensitivity. Given the unique nuances and characteristics of the municipal bond market, several factors come into play when assessing the impact of rising rates. We believe skilled active managers are well-positioned to navigate, and even capitalize on, today’s interest-rate environment.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
There is no assurance that the investment objectives can be met. It is not possible to invest directly in an index. All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. A portion of the municipal bond fund’s income may be subject to state and local taxes or the alternative minimum tax. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner. Municipal bond risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities.
Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, borrower industry concentration, and limited liquidity. Securities purchased by the Fund that are liquid at the time of purchase may subsequently become illiquid due to events relating to the issuer of the securities, market events, economic conditions, or investor perceptions. As a result, an investor could pay more than the market value when buying Fund shares or receive less than the market value when selling Fund shares.
Advance refunding is a financing technique that allows an issuer to obtain the benefit of lower interest rates when the outstanding bonds are not currently callable. The proceeds from the sale of the refunding bonds are used to purchase taxable government securities, which are deposited in an escrow account.
Bond insurance (also known as “financial guaranty insurance”) is a type of insurance whereby an insurance company guarantees scheduled payments of interest and principal on a bond or other security in the event of a payment default by the issuer of the bond or security.
A callable bond is a bond that can be redeemed by the issuer prior to its maturity.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
Duration measures interest-rate sensitivity. The longer the duration, the greater the expected volatility as rates change. Fixed Income investing entails credit and interest-rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall.
Duration neutral seeks to provide exposure to the municipal bond market while protecting against loss of principal when interest rates rise.
Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread (also known as quoted margin). The spread is a rate that remains constant.
Income Return is the percentage of the total return generated by the income from property, fund, or account operations.
Interest Rate Hedging – The borrower can lock in a fixed rate and limit the interest rate risk, or use a variable rate as a way to save interest expense provided that rates don’t rise significantly. Another option is to use a mixed approach, hedging variable rates by locking in a fixed rate for a portion of the loan.
A premium bond is a bond trading above its par value; a bond trades at a premium when it offers a coupon rate higher than prevailing interest rates.
The price return is the rate of return on an investment portfolio, where the return measure takes into account only the capital appreciation of the portfolio, while the income generated by the assets in the portfolio, in the form of interest and dividends, is ignored.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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MacKay Shields LLC is a federally registered investment advisor and an affiliate of New York Life Investment Management LLC. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.