Schwab Bond Insights: California Municipal Bonds, TIPS, FAQs

Key Points

  • As the California economy recovers, the state's municipal bond returns have outpaced the broader market. 
  • Consumer prices are rising at close to the Federal Reserve's target rate, improving the valuations for Treasury Inflation-Protected Securities.
  • We discuss the potential impact of improving economic news on the Fed's interest rate timeline, expected changes in the yield curve, the outlook for floaters, and risks to income-oriented investments.

Bond investors waiting for higher long-term Treasury yields continue to be disappointed. After ending 2013 at 3.03%, 10-year Treasury yields have steadily moved lower. They currently offer a yield of 2.47% (as of August 6, 2014).  While that doesn’t help investors who have been looking for higher yields, it has helped drive positive year-to-date total returns.

Year-to-date total returns have been positive

Year-to-date total returns have been positive

Source: Barclays. Year-to-date total returns as of August 5, 2014. Barclays U.S. Aggregate Bond Index, Barclays U.S. Treasury Bond Index, Barclays U.S. Corporate Bond Index, Barclays U.S. Corporate High-Yield Bond Index, Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index, Barclays Municipal Bond Index. Returns assume reinvestment of interest and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

Still, the performance of the U.S. Treasury Bond Index has lagged other fixed income investments, mainly due to the shorter duration the index has. Since long-term bond yields have fallen more than short- and intermediate-term, the index has generally lagged those indexes with higher durations or those that offer higher yields due to increased credit risk. Below we answer some frequently asked questions about the Treasury yield curve, and what we might expect from the Fed going forward.

Municipal bonds have posted some of strongest fixed-income results so far this year. Despite the headlines with some troubled municipalities, the municipal bond market overall is in good shape in our view, as municipalities have generally improved their finances. Below we discuss recent developments with California municipal bonds.

U.S. Treasury Inflation-Protected Securities, or TIPS, continue to perform well, due to a combination of their higher average duration relative to the broad Treasury bond market, as well as a recent increase in inflation expectations. Is now the time to invest in TIPS? Find out below.

Turnaround in California municipal market

There’s been quite a turnaround in California. A little more than two years ago, the state's general obligation (GO) municipal bonds were the lowest-rated of any state, and California was the "black eye" of the muni market.

Now the Golden State’s finances are looking much brighter. The Barclays California Municipal Bond Index has returned 7.24% year-to-date, outpacing the broad Barclays Municipal Bond Index by more than 80 basis points.1 And all three major ratings agencies have recently upgraded the state's GO bonds.

What should investors know and what investment options are available to take advantage of the state's improving economy?

California economy rebounds

With 12% of the total U.S. population and a very diverse economy, California has benefited from the national economic recovery. "The state is on track to finish the year in its strongest fiscal position of the past decade," according to Standard & Poor's. It will have its largest surplus in more than a decade in fiscal year 2015,2 at more than $6 billion, according to recent projections from the Legislative Analyst's Office.

Non-economic factors have also contributed to the state's financial recovery. In 2010, California voters approved a measure that lowered the threshold for passing a budget from a two-thirds majority in the legislature to a simple majority.

Previously, the state's budget had only been signed on time in four out of 22 years. Now, for two years running, the state has delivered an on-time and balanced budget. Passing on-time budgets helps the state:

  • Take advantage of increased financial flexibility
  • Manage state payments in a timely fashion
  • Avoid annual liquidity shortfalls

As a result of its financial recovery, the state's GO ratings are the highest in nearly a decade. Moody's raised California's GO rating to Aa3 from A1 in June, putting its GO bonds in the Aa category for the first time since 2001. ''The ratings agency said California's financial position is rapidly improving, debt is declining, and the state is making governance improvements to protect itself in the future."3 Standard & Poor's rates the state's GO bonds A with a positive outlook.

Steps toward increased fiscal stability

Gov. Jerry Brown's proposal to pay down the state's "wall of debt" is a positive development, in our opinion. During the recent economic downturn, California chose to defer payments to school districts, the retirement system, and other liabilities in an effort to meet its other, higher-priority liabilities. As part of the 2015 budget proposal, the governor has proposed to begin to make up the deferred payments to education funding and pay off economic recovery bonds by 2017.

These plans were supported by Proposition 30, a measure approved by state voters to increase taxes on higher-income earners. The tax took effect in 2012 and expires in 2018. We view this as another positive sign for the state. Rather than directing the recent revenue windfalls toward increased spending, the state has used these funds to address liabilities and fund school districts.

The governor's proposed rainy-day fund should help to address California's volatile revenue stream. Relative to other states, California has a high reliance on capital gains taxes. As a result, when the stock market is doing well, as has been the case recently, revenues are high. But when the stock market is doing poorly, California's revenues tend to suffer, in our view.

We think the rainy-day fund is a favorable development for two reasons. First, it shows that the state is being more fiscally responsible. Second, having a rainy-day fund available should help keep ups and downs in revenues from torpedoing the state's budget.

California has a more volatile revenue stream than other states

California has a more volatile revenue stream than other states

Source: The Nelson A. Rockefeller Institute of Government, as of Q4 2013

Hurdles ahead

It's ironic that Gov. Brown is creating a rainy-day fund for emergencies when rainy days are exactly what the state needs. As the California drought moves into its third year, some investors have questioned what the effect will be on both the state's GO bonds and the water utility bonds in the state.

Moody's believes the drought "will not have a material adverse effect on (the) credit profile" of state or local governments. Agriculture accounts for less than 2% of the state's GDP.  However, agriculture-dependent areas tend to have higher unemployment and poverty rates and lower average wealth than the rest of the state. If the drought continues, it may affect the economies of these areas.

In response to the drought, California has adopted new restrictions on water consumption. We're concerned that the credit quality of less-flexible water utilities could weaken if water sales drop steeply. Utilities with low debt service coverage ratios and less flexibility to adjust rates are most likely to see their credit quality affected.

California faces other hurdles as well, including:

  • The scheduled expiration of temporary sales tax and income tax hikes starting in fiscal year 2017, which could hurt revenues if the taxes are not renewed.
  • Its high pension obligation, which accounts for approximately two-thirds of its revenues.4

Who will benefit from state's economic recovery?

We think California GO bonds and local school district GO bonds, in particular, will be the most positively impacted by the state's economic recovery. Higher revenues will give the state more flexibility to meet its debt service. State GO bonds are a dedicated pledge by the state that are second only to education funding in terms of priority of payments from the state's general fund.

In our opinion, local school district GO bonds should also benefit due to their solid tax backing. Local school district bonds are generally secured by an unlimited and dedicated property tax pledge. They generally also have strong state oversight. The underlying economics and characteristics of the district's tax bases will vary widely, though. In our opinion, districts with a larger and wealthier tax base will generally have stronger tax bases available to pay debt service.

To find California local school district bonds online, go to Research > Bonds and Fixed Income > Find Bonds & Fixed Income and search by the Bond Type as Municipals, the State as California, the Funding as General Obligation and the Purpose Class as School District. You can also call your local Schwab representative for assistance. Prior to making an investment choice, please consult with your local Schwab representative to determine what is appropriate given your unique situation.

Finding local school district bonds online

Finding local school district bonds online

Source: Schwab.com, for illustration only and not to be viewed as a security recommendation to buy or sell.

Is Now the Time to Invest in TIPS?

Now that inflation is hitting the Federal Reserve's target level of 2%, should investors be adding Treasury Inflation-Protected Securities (TIPS) to their portfolios? The recent rise in inflation gives us a more favorable view on the valuation of TIPS.

We doubt there will be a significant spike in inflation in the near term, but for those investors looking for inflation protection we think TIPS are reasonably valued in today's market. Still, investors should be aware of some nuances before diving head first into these types of investments.

What are TIPS?

TIPS are a type of Treasury bond in which the principal value rises and falls with the level of inflation. The inflation index used for TIPS is the Consumer Price Index for All Urban Consumers (CPI-U). Like traditional Treasury bonds, TIPS are issued with a fixed coupon rate, based off the bond's principal amount. Since the principal amount of a TIPS will fluctuate with inflation, so too will the coupon amount.

To better illustrate, let's consider a TIPS that has a 1% coupon, a face value of $10,000, and matures in 10 years. If in the first year there is no inflation, the principal value of this TIPS will stay at $10,000 and the investor will receive a coupon payment of $100—or 1% of $10,000. If in the second year CPI-U increases by 3%, the principal value of the TIPS will increase by 3% to $10,300 and the coupon payment will be $103—or 1% of the $10,300 principal value.

One important characteristic of TIPS is that the principal value increases—indefinitely—with rising inflation. At maturity, the securities will pay the higher of the inflated value or the original principal value. They will never pay below the original principal value at maturity. That's important during deflationary periods.

Using our example above, the TIPS will always pay, at a minimum, $10,000 at maturity even if consumer prices have fallen. That doesn't mean you can't see your principal decline if you invest in TIPS, though.

Investors who purchase TIPS in the secondary market may be buying securities with substantial accrued principal. If deflation occurs after their purchase, they could see their maturing principal fall, resulting in a loss. For example, if an investor were to buy our hypothetical TIPS in the secondary market when it had an inflated principal value of $10,300, deflation could reduce the principal amount, and it could drop to $10,000 by maturity.

The coupon rate, however, is always based on the adjusted principal, even if the principal value falls below $10,000.

Inflation on the rise

Most inflation indicators, such as the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE) deflator, have risen over the past few months. In June, the year-over-year change in the CPI was 2.1%, marking the third straight month of increases of 2% or higher. The last time the year-over-year CPI rose by 2% or more was in February 2013.

The PCE deflator, the Fed's preferred measure of inflation, has been climbing as well, rising at a 1.8% annual rate in May, the highest reading since October 2012. Even so-called "core" price increases—those that strip out the highly volatile food and energy prices—have been on the rise.

Inflation indicators have been trending higher

Inflation indicators have been trending higher

Source: St. Louis Federal Reserve. Personal Consumption Expenditures: Chain-type Price Index (PCEPI), Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL), Consumer Price Index for All Urban Consumers: All Items Less Food & Energy (CPILFESL), Percent Change from Year Ago, Monthly, Seasonally Adjusted.  CPI data as of June 30, 2014, PCE data as of May 31, 2014.

Evaluating TIPS using breakeven rates

When you're evaluating TIPS, you'll want to know not just the level of inflation, but also how a TIPS compares to a traditional Treasury bond. The difference between the yield on a Treasury bond and a TIPS with a similar maturity is the breakeven rate.

This rate is what inflation, as measured by the CPI, needs to average over the remaining life of the TIPS for it to match a Treasury bond's performance. For example, if a 10-year Treasury bond offered a yield of 2.5% and a 10-year TIPS offered a yield of 0.2%, then the breakeven rate would be 2.3%. That means the CPI would need to average 2.3% on a year-over-year basis until the TIPS matured for it to deliver a return comparable to a traditional Treasury bond.

The five-year breakeven rate is currently 2.02%, while the 10-year inflation rate is 2.27%.5 Although these rates have risen recently, they have risen by a smaller amount than actual inflation.

Since the Fed's preferred range of inflation is around 2%, we prefer to invest in TIPS when the breakeven rates are close to that level, as they are today. Both the five-year and 10-year TIPS breakeven rates are close to the 2.1% rise in CPI over the past two months, so we think valuations appear reasonable.

Breakeven rates are near the Fed’s targeted inflation range

Breakeven rates are near the Fed’s targeted inflation range

Note: Breakeven inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.
Source: Bloomberg, monthly breakeven rates as of July 28, 2014.

Watch the duration of TIPS

Duration is a measure of interest rate sensitivity. All else being equal, the higher the duration, the more sensitive a bond will be to interest rate changes, and vice versa. Since a bond's price and yield move in opposite directions, understanding duration can help you get a sense of what may happen to your bond investment when interest rates are changing.

The Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index has an average duration of 7.61, compared to an average duration of 5.30 for the Barclays U.S. Treasury Bond Index,6 indicating that TIPS are more interest-rate sensitive. One factor driving the higher duration is the average maturities of TIPS.

Since TIPS are issued with initial maturities of five, 10, and 30 years, an index of TIPS generally has a higher duration than an index of all traditional Treasury bonds. That's because a large part of traditional Treasury bond issuance is concentrated in shorter maturities. TIPS also have lower coupons than traditional Treasury bonds, also leading to a higher duration.

What to do now?

If you're looking for inflation protection, TIPS may make sense today. With breakeven rates close to their historical averages and close to the Fed's targeted inflation range, we think they offer reasonable value.

When investing in TIPS, keep an eye on both the inflation rate and the breakeven rate. If breakeven rates continue to move higher on expectations of higher inflation in the future, then you may be paying too much for that inflation protection. We'd prefer to stick with breakeven rates that are close to the Fed's inflation target of 2%.

And remember, TIPS are still bonds that can suffer price declines if interest rates rise, so don't be caught off guard if TIPS suffer price declines if Treasury yields move higher.

You can find TIPS online at schwab.com by going to Research > Bonds and Fixed Income > Find Bonds and Fixed Income and selecting "Treasuries" as the bond type with "Include Only" TIPS selected for secondary issued TIPS. To purchase TIPS at auction, select "Buy Treasuries at Auction."

Finding TIPS online

Finding TIPS online

Frequently Asked Questions on Fixed Income Investments

Has the recent positive economic data changed your view on the timing of the Fed's first rate hike?

No. It still appears the Fed is on course for the first rate hike of this cycle in mid-2015. The minutes of the July FOMC meeting indicated that the Fed would most likely wait a "considerable time" after ending its bond buying program before raising short-term interest rates. The bond buying program is likely to end in October or November. Federal Reserve Chair Janet Yellen said at a press conference earlier this year that a "considerable time" may be around six months. It's important to keep in mind, however, that the Fed has indicated all along that the decision to change policy is dependent on economic data.

Economic data for the second quarter have been stronger than in the first quarter, when GDP growth contracted by 2.1%, partly due to severe winter weather. The first reading for GDP growth in Q2 was 4%. Inflation, as measured by the Fed's favored indicator, the deflator for personal consumption expenditures (PCE), has risen at a 1.6% year-over-year rate, close to the Fed's 2% target level.7

The two data points have led many—both within the FOMC and elsewhere—to conclude that the Fed might raise rates sooner than mid-2015. There certainly appears to be disagreement among various Fed officials about the timing. Both Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser have indicated they believe an earlier rate hike is warranted.

However, we would note that the economic data have not been consistently strong and inflation is holding near 2%. For example, much of the increase in the Q2 GDP estimate was due to a rise in inventories, which may suggest slower production as those inventories are drawn down. Also, housing activity has slowed substantially this year.

Moreover, the majority of Fed officials are focused on unemployment. One measure they're watching is the high level of "underemployment," which includes those who are working part-time because they can't find a full-time job, as well as those who are marginally attached to the workforce. Additionally, the number of people unemployed for over six months remains above 30%—high by historical standards.

The percent out of work for 27 weeks or longer remains high

The percent out of work for 27 weeks or longer continues to remain high

Source: St. Louis Federal Reserve percent of Total Unemployed, Percent Unemployed 27 Weeks and over (LNU03025703), Percent, Monthly, Not Seasonally Adjusted. Shaded areas indicate past recessions. Data as of July 2014.

These readings suggest to many at the Fed that there is still considerable room for unemployment to fall before wage pressures begin to push up inflation. And recent data on wages show they continue to rise at a pace that's hovered around 2% year-over-year, while inflation expectations remain fairly stable.

How do you think the yield curve will change as we get closer to the first Fed rate hike?

We expect the yield curve to flatten as the first Fed rate increase of the cycle approaches, meaning that short-term yields will rise more than long-term yields. This was the pattern in the past three Fed rate hike cycles--in 1993-94, 1998-2000 and 2003-06. In each case, more than half of the increase in 10-year Treasury yields from the cycle trough to peak occurred before the first Fed rate hike, and then yields on the short end of the curve began to follow suit. It seems likely to us that if the Fed begins to raise short-term rates next year as indicated, a similar pattern will unfold, for three reasons.

First, short-term interest rates are still near zero, where they have been for nearly five years. Meanwhile, long-term rates have already risen by nearly 100 basis points from the lows of last year. A basis point is one-hundredth of a percentage point. And with inflation at 2%, short-term rates are negative in real terms, while real long-term rates are at least positive. It appears to us that the process of "normalizing" interest rates has already begun for longer-term rates but not for short-term rates.

Second, inflation and inflation expectations are relatively stable. While short-term interest rates are heavily influenced by Fed policy, long-term rates are influenced to a great extent by inflation expectations. Currently the indicators for inflation expectations that we follow, such as the implied inflation expectations in the TIPS market, suggest that expectations remain steady near 2%.

Third, the yield curve is already quite steep by historical standards. Although the yield curve has flattened since the start of the year as long-term rates have fallen while short-to-intermediate term rates for two-year to five-year bonds have risen, the difference is still wide compared to the long-term average. Over the past ten years, the average difference has been 95 basis points. It currently stands at over 200 basis points.

Spread between 2-year and 10-year Treasuries

Spread between 2-year and 10-year Treasuries

Source: Federal Reserve Bank of St. Louis. Series is calculated as the spread between the 10-Year Treasury Constant Maturity and the 2-Year Treasury Constant Maturity, as of July 1, 2014.

How should investors position themselves?

There is no one right answer for how to position a portfolio for the potential of a flattening yield curve as interest rates rise. Short-term bonds are the least sensitive to rising rates and offer the flexibility for more frequent reinvestment as rates move up. However, yields on short-term bonds are very low. That means a portfolio heavily weighted to short-term bonds will likely not earn much income and if interest rates don't rise rapidly, the investor could lose out on the opportunity for interest income.

Long-term bonds, however, are the most sensitive to rising interest rates. Therefore, a portfolio with a heavy concentration of longer-term bonds could experience a lot of price volatility and the investor could miss out on the opportunity to reinvest as rates rise.

We suggest investors consider spreading out the maturities of bonds in a portfolio across time by using a bond ladder with an average duration in the intermediate term, meaning five to 10 years for taxable bonds and seven to 12 years for municipal bonds. The portfolio would still be susceptible to price declines as interest rates rise, but the short-term bonds allow flexibility to reinvest if rates rise, while the longer-term bonds provide current income.

If you expect short-term rates to rise, do Treasury floating-rate bonds make sense now?

We think Treasury floating-rate notes, or floaters, make more sense today than earlier this year. However, we think it still may be too early to invest in them and that they'll likely be more attractive as the Fed's first rate hike gets closer.

Floaters are a type of debt without a fixed coupon rate—instead, they "float" off a benchmark rate. In the case of Treasury floaters, the coupon is based off the 13-week Treasury bill auction, which is closely tied to the Fed funds rate.

If the Fed's first rate hike of this cycle occurs in mid-2015, an investor in Treasury floaters today might not see his coupon payments increase for the next nine to 12 months. Today, two-year Treasury floaters offer a yield of about 0.06% compared to a fixed-rate two-year Treasury note yield of 0.47%.By investing in Treasury floaters today, you'll be at a disadvantage compared to fixed-rate notes unless the Fed raises rates sooner than anticipated.

Effective Fed funds rate and 3-month Treasury bill yields move together

Effective Fed funds rate and 3-month Treasury bill yields move together

Source: Federal Reserve Bank of St. Louis, as of July 1, 2014.

Since yields are still low, I have been investing in other income-oriented investments. How do you think they will perform if long-term rates rise?

Many income-oriented investments, like real estate investment trusts (REITs) and master limited partnerships (MLPs), for example, can be affected by rising Treasury yields. We looked at periods where the 10-year Treasury yield rose in a relatively short period of time and found that these investments have tended to:

  • Underperform the broad equity markets and even the bond markets at times
  • Behave more like bonds in terms of sensitivity to interest rates and may lose some of their diversification benefits

When evaluating these relationships, we looked at all periods from 1993 when the 10-year Treasury increased by 100 basis points in a short period of time. We found 10 periods that fit these criteria, all lasting 16 months or less.

This table below shows periods of rising yields and the investment performance of various types of investments.

Investment performance and rising 10-year Treasury yields

Investment performance and rising 10-year Treasury yields

Source: Schwab Center for Financial Research, Barclays and Bloomberg. Indices used are: S&P 500 Total Return Index, S&P U.S. REIT Total Return Index, Alerian MLP Total Return Index, Dow Jones U.S. Utilities Total Return Index, and Barclays U.S. Aggregate Bond Index. Change in yield is represented by the US Generic Govt 10 Year Yield (USGG10YR).
Note: Data for the 10/15/93 to 11/7/94 period was unavailable for MLPs. Past performance is no guarantee of future results.

Although this study was based on historical performance, it may give us some insight as to what may happen going forward. Based on the 10 periods in our study, we were able to draw some conclusions:

  • Investments designed to provide both capital appreciation and income (such as a broad stock index) tended to outperform those that are mostly yield-oriented (such as bonds or utility stocks).
  • Investments that are mostly yield-oriented and therefore very sensitive to interest rate changes tended to have the weakest performance.
  • Yield-oriented equity investments tended to be more volatile than bonds during rising interest rate periods.
  • During periods of rising long-term Treasury yields, the correlations between yield-oriented equity investments and the broad equity market tended to decline, while correlations between yield-oriented equity investments and bonds tended to increase.9

It's important to realize that the prices of income-oriented investments like REITs, MLPs, or utility stocks may be adversely affected by rising interest rates. If you've been investing in these types of securities due to the relatively high yields they offer, remember that they are still equity investments that can be volatile and suffer price declines. Many securities offer income, but other investments may not offer the diversification benefits that bonds do in a portfolio.

I hope this enhanced your understanding of fixed-income investments. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

 

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