Is the Muni Bond Rout Over, or Is There More to Come?

Key Points
  • The recent rout in the municipal bond market can be unsettling, but it hasn’t changed our view on the attractiveness of municipal bonds for many investors.

  • While interest rates have risen recently, we expect rates to level off later this year or in early 2019.

  • We suggest investors focus on higher-rated issuers and target an average duration between five and eight years.

Municipal bond yields spiked in early October—to 3.01% from 2.86%¹—causing returns to decline by 0.9% in just six trading days. While a decline of that magnitude over that short a time period may be common for some asset classes, it’s relatively rare for munis and has caused some angst for investors.

Despite the recent volatility, we don’t think investors should abandon munis. We believe they remain an attractive option for high-income earners, and the recent uptick in volatility hasn’t changed that view. In fact, the recent rise in yields is actually beneficial to income-oriented investors if they’re invested appropriately. However, there are action steps—which we’ll discuss below—that investors may want to consider.

Munis haven’t been the only bonds to take it on the chin

The recent rise in yields—and decline in prices, which generally move inversely to yields—was not isolated to municipal bonds. It was primarily due to Federal Reserve Chairman Jerome Powell’s comment in early October that the Fed was a “long way” from getting the federal funds rate back to a more normal level. The comments caused the yield on the 10-year Treasury to increase to 3.23% from 3.06%². Yields for most bonds, including munis, rose as a result of Powell’s comments. As the chart below illustrates, total returns since his comments were negative for most major bond asset classes.

While it can be unsettling to experience a sudden decline in your bond prices, we believe that most investors should take a longer approach to investing than a few weeks. As the chart also illustrates, total returns viewed over a longer time horizon—for example, since the beginning of 2017—have been much better.

Investors should focus on longer-term returns, not short-term changes

While total return for municipal bonds was negative 0.70% between Oct. 1 to 18, total return was 4.28% from 2017 through Oct. 18. High-yield municipal bonds total return was negative 1.32% from Oct. 1 to 18, but was 13.05% from 2017 through Oct. 18.

Source: Bloomberg Barclays Indices, as of 10/18/2018. Past performance is no guarantee of future results.

Action Step 1: Don’t overreact and stay invested; the worst may already be behind us.

Munis tend to move in the same direction as Treasury bonds, and we think the rise in Treasury yields is likely near the peak for this cycle. We’ve found that Treasury bond yields of all maturities tend to top out near the peak the federal funds rate, a key overnight lending rate that the Fed uses to adjust monetary policy. Based on the Fed’s most recent projections, the peak in the federal funds rate is expected to be in the 3.25% to 3.5% area. We believe it could settle slightly lower than the median projections indicate. While there’s still some possible upside in yields, based on history, the largest move up in yield is likely behind us.

The 10-year Treasury and federal funds rate have tended to peak near the same level in the past

The 10-year Treasury yield and the federal funds rate historically have peaked near the same level, that is, in the 9% range in 1987, in the 6% range in 2000 and in the 5% range in 2006.

Source: Bloomberg, as of 10/18/2018.

While the prospect of rising interest rates may cause some investors to avoid munis or wait until interest rates rise to invest, we believe it’s better to focus on the opportunity the back-up in yields provides to add income to portfolios that is typically exempt from federal income tax. It may be tempting to try to time the peak in interest rates, but it is notoriously difficult. Moreover, every day that you’re not invested you’re forgoing higher interest payments, which can add up substantially over time.

One strategy we suggest is a bond ladder. One benefit of a bond ladder is that it removes the uncertainty of trying to time interest rates. Also, your portfolio can benefit if interest rates rise. For example, consider a five-year ladder with $50,000 invested in each rung of the ladder. In the chart below, both hypothetical portfolios follow a ladder strategy and assume that proceeds from maturing bonds are reinvested each year in a new AAA-rated five-year bond. In one portfolio, interest rates for five-year munis remained the same, while in the other rates increased by 25 basis points every year. In both cases, the income from coupon payments would increase over time. However, interest income would increase more if interest rates rose.

An increase of 25 basis points every year isn’t our base-case scenario, but we want to highlight how rising interest rates can benefit an appropriately positioned portfolio. The chart also doesn’t reflect the fact that when interest rates rise, prices decline. But if you’re in a laddered strategy and you hold until maturity, you know with certainty, barring default, how much you’ll receive back and when you’ll receive it.

A ladder strategy can benefit investors more when interest rates are rising

In a bond ladder with 5-year yields unchanged, interest income is $5,364 in year 1, $5,538 in year 2, $5,665 in year 3, $5,756 in year 4, and $5,803 in year 5. If yields rose by 25 bps annually, income would be $5,364, $5,663, $6,040, $6,506 and $7,053.

Source: Schwab Center for Financial Research, as of 10/18/2018.

Both strategies utilized ladder strategies. Example assumes a starting yield of 1.97%, 2.07%, 2.14%, 2.23%, and 2.32% for one, two, three, four, and five-year maturities, respectively, and that investor purchases a new five-year bond each year. $50,000 is invested in each maturity to begin and as each bond matures it is reinvested in a new five-year maturity. Blue bars assume an annual increase of 25 basis points each year in the five-year maturity yield, while grey bars assume no annual yield increase for the five-year maturity. Chart is hypothetical and for illustrative purposes only.

Action Step 2: Match your investments with your time horizon, and check your funds.

The recent market volatility highlights the importance of matching your investments to your time horizon. Since Powell’s comments, returns for longer-term bonds have been much lower than for short-term bonds. For muni investors that have short-term needs, we strongly suggest that you match the duration of your investments to when you’ll need the money. Mutual fund and exchange-traded fund (ETF) investors can find the duration of their funds on the Research page on schwab.com.

The relative attractiveness of munis is generally measured by the municipals-over-bonds, or MOB, spread. It compares the yield on a AAA-rated municipal bond to that of a Treasury bond of equal maturity, before accounting for taxes. As shown in the chart below, the MOB spreads for all maturities are below their longer-term averages, and especially so for shorter-term munis.

Relative valuations are below their longer-term averages

The 2-year MOB is 72.1, below its longer-term average of 87.5; 3-year MOB is 72.5, below its average of 83.3; 5-year MOB is 76.8, below its average of 81.9; 5-year MOB is 81.1, below its average of 85.2; 10-year MOB is 87.1, below its average of 94.

Source: Bloomberg, as of 10/18/2018.

For muni investors with a longer time horizon, it may make sense to target an average duration between five and eight years. By targeting an average duration between five and eight years, you can take advantage of the more attractive valuations on the longer end of the muni yield curve while still not investing in munis with maturities that are too long. Bonds with longer maturities are more sensitive to rising interest rates. Keep in mind that we suggest an average between five and eight years—so some longer-term bonds should be balanced out with shorter-term bonds. But above all else, remember to match your investments to when you need the money.

Action Step 3: Stick with higher-rated bonds

Although we don’t anticipate a recession any time soon, we believe we are in the later part of the economic cycle, and think muni investors should start preparing for a potential economic slowdown. Lower-rated muni issuers tend to have less financial flexibility to meet debt service, and during an economic slowdown their finances may be further strained, which could result in ratings downgrades. When a bond is downgraded its price generally falls.

Moreover, higher-rated munis historically have provided better diversification to equities – especially during periods of high equity market volatility. Correlation measures how closely returns for two investments move together. A positive correlation means returns for the two assets move closely together and they do not provide good diversification from one another. Whereas the opposite is true for negative correlation—returns for the two assets move in opposite directions and they provide good diversification from one another.

As shown in the chart below, the correlation between stocks and municipal bonds of various credit ratings increases as you move further down the credit rating spectrum. In other words, AAA-rated munis provide better diversification from equities than do Baa-rated munis. This is especially true during periods of heighted equity market volatility. We found that during periods of higher-than-average equity market volatility3, as measured by the Cboe Volatility Index (VIX), the diversification benefits of higher-rated munis improve even more.

Higher-rated munis can provide better diversification benefits during high stock market volatility

On all days from 4/30/98 to 9/28/18, muni bond correlations to the S&P 500 were: BBB 0.16; A .09; AA .05; AAA .02. On days when the VIX was above its 100-day moving average, correlations were BBB 0.14; A .05; AA minus .01; AAA minus .08.

Source: Schwab Center for Financial Research using data from Bloomberg. Monthly data from 4/30/98 to 9/28/18. Municipal bonds are represented by the Bloomberg Barclays Municipal Bond Index and stocks are represented by the S&P 500® index.

Keep in mind the tax benefits that munis can offer

Not only can munis help smooth out portfolio volatility due to their potential diversification benefits, but they also can offer tax benefits. The interest income received on munis is generally exempt from federal and state income taxes if purchased from your home state. This can be an attractive feature for high-income earners. For example, a California investor in the top state and federal tax bracket would have to earn more than 6.5% on a fully taxable bond to achieve the same after-tax yield as a California muni yielding 3.0%.

What to do now

Muni investors who are invested in individual bonds should review the maturities and credit ratings of their bonds to see if they still meet their investment goals. A Schwab fixed income specialist can help by running a report to analyze your individual holdings.

Muni investors using mutual funds or ETFs can review their funds on the Research page of Schwab.com. There, you can find a breakdown of the fund’s investments by credit rating and maturity.

 

¹ As of Oct. 18, 2018 and Oct. 2, 2018.

² As of Oct. 5, 2018 and Oct. 2, 2018.

³ Defined as periods where the VIX is greater than is 100-day moving average

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
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