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