Why it's a good bet to stay invested while the Fed delays
Municipal bond investors are in a good position to wait out the Federal Reserve, after policy makers left the target interest rate unchanged and signaled increases will be gradual, strategists said.
Investors have variety of strategies at their disposal — from favoring high quality, intermediate bonds to staying fully invested and buffering potential rate risk with premium coupons — to take advantage of buying opportunities while they monitor the potential for a rate hike that now may come later than previously expected.
"We stay focused on our long-term investment objectives, not re-positioning for each incremental move in Fed policy, but analyzing how the direction of policy and economic developments affect our markets," says Dorothy Thomas at Regions Investment Management.
The markets have been anticipating the Fed's next rate rise ever since it raised its target for the federal funds rate 25 basis points in December 2015 for the first time since 2006. At the time, the Fed raised its target by 25 basis points to 5.25%, the last in a string of 17 straight interest-rate increases that had begun in June 2004.
Prior to the release on May 18 of the April Federal Open Market Committee meeting minutes, the financial markets were pricing in less than 20% of a rate hike at the June meeting.
"The Fed has clearly signaled that policy moves are coming, although the expected timing keeps shifting," said Dorothy Thomas, senior vice president and director of tax-exempt fixed income for Regions Investment Management. Regions is an RIA that oversees the management of $9.7 billion in client assets.
She said the looming "Brexit" vote in the U.K., was one reason the Fed would be wary of raising rates now. For the first time in 40 years, the British people will vote on June 23 whether the United Kingdom will remain in the European Union or depart amid growing political opposition to the union.
Given the potential rate volatility and political uncertainty overseas, analysts recommend paying more attention to asset allocation and portfolio positioning — and how a variety of strategies can help their overall performance — and less about the actual timing of the rate hike.
Brian Rehling, managing director and co-head of Global Fixed Income Strategy at Wells Fargo Investment Institute, said before Wednesday's decision that he expects only one increase before year-end as the FOMC continues its cautious approach to rate hikes in the second half of 2016. "Although municipal securities slightly underperformed their taxable counterparts in the first half of the year, we believe they offer attractive taxable equivalent return opportunities and are well positioned for growth through the rest of 2016," he said in a June 14 Global Fixed Income Strategy Report.
Rehling said focusing on issues rated A or better as well as remaining active in the intermediate part of the yield curve and owning bonds with premium coupons are advantageous strategies ahead of a rate hike.
As of Wednesday, the 10-year triple-A general obligation scale yielded 1.48%, while the 30-year yielded 2.18%, according to Municipal Market Data.
Rehling suggests holding bonds to maturity and staying fully invested as two other strategies that will buffer investors against imminent rate volatility.
"As the municipal market changes, market prices will fluctuate — until the bond matures but at maturity investors will receive the face value or par for the individual security as long as the issuer does not default," he said. Staying fully invested can give investors significant income generation, he said, offsetting some or all of a decline in the underlying market price during a rising rate environment.
Bonds offered at substantial premiums to par, he added, can generally be purchased at higher yields than comparable par or discount bonds, and, therefore, frequently have a higher yield to maturity. "Premium bonds also offer a distinct advantage in a rising rate environment as they tend to lose less value than a comparable bond purchased at par or a discount," Rehling said.
For some, including Thomas, the rate hike itself has less impact on investment strategy, and more impact on market conditions as a whole.
"We stay focused on our long-term investment objectives, not re-positioning for each incremental move in Fed policy, but analyzing how the direction of policy and economic developments affect our markets," Thomas said.
She is maintaining a defensive position of relatively short maturity structures, high coupons, and strong credit quality profiles as she has for some time, and takes opportunities when they arise.
"We expect to generate cash flow to reinvest in a modestly rising rate environment later this year and into next year," Thomas said.
Regions manages active, diversified strategies through a risk controlled environment for equity, fixed income and balanced portfolios. It has dedicated equity and fixed income research teams, and is able to manage both standard and customized portfolios for clients.
Peter Block, managing director at Samuel A. Ramirez, agreed that municipal bonds are relatively attractive and offer value for investors using a strategy rooted in owning higher credit quality and shorter effective durations, which should outperform longer duration and lower quality strategies.
"Munis continue to appear cheap on a global basis and, as a broad asset class, have outperformed most other credit assets on a risk-adjusted basis in 2016," Block said in an interview last week.
Shortening effective duration reduces risk in a rising rate environment — even when the actual rate hike occurs beyond the market's perceived timing, he said.
"When the Fed does act, we think Treasury rates are likely to move upward in a measured pace, which all else equal, should not adversely affect muni market demand," Block said.
Municipal bond funds reported inflows for the 36th consecutive week, according to Lipper data released on June 9. Weekly reporting funds saw inflows nearly double, with $852.5 million of inflows in the week ended June 8, after inflows of $473.2 million in the previous week, Lipper said.
The S&P Main Index, he noted, had a total return that equaled 2.90% year to date, or 2.09% on a risk-adjusted basis, and had a 6.46% total return over last 12 months, or 4.47% risk-adjusted.
"These factors should help maintain positive mutual fund flows and help absorb gross supply, which we forecast at $378 billion total in 2016," Block said.
Forward Treasury curves and the current municipal to U.S. Treasury ratios imply that when the Fed does raise rates, the municipal curve will flatten within one year by about 35 basis points, with about 20 basis points, or 55% of the shift, occurring inside the 10-year spot, Block predicted.
Block said that outcome can be beneficial for clients using different strategies to buffer or find opportunity in a rising rate climate. Ramirez is among the top minority-owned, full-service securities firms in the nation that focuses on municipal bonds, and has provided wealth management, underwriting, banking, institutional brokerage and asset management for nearly 45 years.
"Depending on the investor's portfolio mandates, a barbell approach may work or a bullet strategy may work in targeting shorter duration," Block said. Within a barbell approach, Block favors high grades within five years which have lower dollar prices versus intermediate and long bonds with short embedded calls.
In a bullet strategy, meanwhile, Block prefers the six to 12-year spots on the yield curve. This positioning offers "the best risk-adjusted roll-down returns, which have lower absolute returns than longer maturities, but less risk, and can be more defensive versus other spots on the curve in a rising rate environment."
"Fed funds futures contract prices imply a rate move in July is not likely either, with only an 18% chance of a rate move at that time." Rather, he said the Fed funds futures pricing indicates a rate move at either the September or November meetings is more probable, with approximately a 40% likelihood at both meetings.
"Regardless of the eventual timing of the next rate hike it is important that investors continue to focus on the general path of rate increases," Rehling said in his report. "A deliberate and slow moving Fed coupled with an inflationary environment that remains subdued should help support a low rate environment.
"Rates close to or below zero in many countries should provide additional support to domestic fixed income investments as global investors seek out higher-yielding assets," Rehling added.
Thomas of Regions said if and when the Fed makes a move, the municipal market may take it in stride.
"I think the market has been ready for the Fed's next tightening move for such a long time that it would be surprising if there were a significant reaction when the move eventually takes place," Thomas said.