Municipal bonds today: Don’t time the market
We’ve seen a remarkable u-turn in interest rate expectations over the past 12 months. In November 2018, the yield on the 10-year U.S. Treasury note was as high as 3.24% and by Labor Day 2019 it had dropped all the way to 1.47%. Investment grade municipal bond yields tracked a similar decline, peaking at 3.08% last November1 and declining to 1.65% over nearly the same period.
The intensifying U.S/China trade war, slowing economic growth, and even this summer’s 2-year/10-year Treasury yield curve inversion has sparked fears that a recession could be looming. Now some market experts are predicting that long-term rates in the U.S. will continue to decline, potentially even to zero. Here’s the catch: none of the top prognosticators have been consistently correct in predicting the direction of rates or where the fixed income market is headed. What might happen to municipal bonds if they are wrong?
This question may be causing some investors to second-guess entering the municipal market. It can be easy for investors to stray from long-term goals by attempting to time market fluctuations with short-term investment decisions. We don’t view an allocation to municipal bonds as a tactical trade, but rather as a dedicated part of a complete asset allocation meant to be held for the long-term, regardless of interest rate movements. Let’s consider key reasons why.
Munis Are Not Highly Correlated To Rates
Price movements in the municipal bond market do not move in lockstep with U.S. Treasuries.
Over the trailing 10-year period from 8/31/2009 to 8/31/2019, there were three periods where the 10-year U.S. Treasury rose by 100 bps or more. As noted in the chart below (Figure 1), investment grade municipal bond returns during these periods were only moderately correlated to U.S. Treasury rate increases.
Figure 1: Bloomberg Barclays Municipal Bond Index correlations to the Bloomberg Barclays U.S. Treasury Index during rising rate periods of 100 bps or more 8/31/2009 – 8/31/2019
Bloomberg Barclays Municipal Bond Index correlations to the Bloomberg Barclays U.S. Treasury Index during rising rate periods of 100 bps or more 8/31/2009-8/31/2019. Source: Morningstar, FRED, as of 8/31/2019.
The modest correlation between municipal bond prices and U.S. Treasury yields signals that regardless of the interest rate environment, investors receive diversification benefits from holding municipal bonds over time.
Holding Period Matters
The lower correlation between these asset classes also underscores the importance of investors not getting caught up in trying to time the muni market. Attempting to tactically buy or sell municipal bonds doesn’t necessarily protect investors from losses and could potentially limit total returns over time.
To confirm this, we looked at rolling municipal index returns over the same 10-year period, measuring the returns for Investment Grade, High Yield, Taxable, Short-Term, and Insured municipal bonds (Figure 2).
Figure 2: Rolling municipal index total returns 8/31/2009 – 8/31/2019
Source: Morningstar. Measures the performance of the Bloomberg Barclays Municipal Index (Investment Grade), Bloomberg Barclays High Yield Municipal Index (High Yield), Bloomberg Barclays Taxable Municipal Index (Taxable), Bloomberg Barclays Municipal Bond 3-Year (2-4) Index (Short-Term), and Bloomberg Barclays Insured Municipal Index (Insured) during all rolling periods from 8/31/2009 – 8/31/2019. Returns longer than 12-months are annualized. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
What we found is that when municipal bonds were held for 24 months or more, none of the major indices produced a negative return over any single rolling period. In fact, holding period mattered, as indicated by the worst case returns column in figure 2. Total return potential increased incrementally with each step up in holding time. These results are evidence of the benefits of holding municipal bonds for the long-term and demonstrate how attempting to time a tactical allocation in this asset class can lead to poorer outcomes for investors.
Heightened Demand Supports Municipals
It is clear that investors are continuing to see value in municipal bond funds. The demand is, in part, being driven by the fact that for investors seeking tax-exempt income, municipal bonds are the only game in town. Underscoring this is the reality that efforts by lawmakers to remove the State and Local Tax (SALT) income tax deduction cap of $10,000–set into law as part of the 2017 Tax Cuts and Jobs Act–are not expected to advance anytime soon.2 In August alone, the asset class saw $9.1 billion in positive flows, continuing a steady 2019 trend.3
Active Management Matters
Regardless of the interest rate environment, municipal bonds should continue to be an important part of a diversified, long-term asset allocation. Our perspective remains that a strategic allocation to municipal bonds can also be enhanced via the benefits of active management. As uncertainty in the fixed income markets persists, active managers that are able to take advantage of price weaknesses and market dislocations are well-positioned to add significant outperformance over passive approaches.
1. Source: U.S. Department of the Treasury as of 9/12/2019. Investment grade municipal bonds represented by the Bloomberg Barclays Municipal Bond Index.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value. Actively managed funds have higher fees than passively managed funds.
Correlation matrices present in a table format whether or not “different” investments will move at the same time for the same reason and in the same direction. If true, they have a correlation of plus 1. If, on the other hand, they were to move in exactly opposite direction they would have a negative correlation of minus 1.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
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. A portion of the Fund’s income may be subject to state and local taxes or the alternative minimum tax. Income from municipal bonds held by the Fund could be declared taxable because of unfavorable changes in tax law, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. High-yield municipal bonds may be subject to increased liquidity risk as compared to other high-yield debt securities. The Fund may invest in derivatives, which may increase the volatility of the Fund’s NAV. 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.
Neither New York Life Investment Management LLC, nor its affiliates or representatives provide tax, legal or accounting advice. Please contact your own professionals.
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