June Municipal Market Commentary

Municipal Portfolios: Achieving Positive Total Returns in a Rising Interest Rate Environment

  • Interest rate increases are not instantaneous; model the timing of the rate move
  • History suggests dire predictions for long-term rates are unfounded
  • Compare today’s benchmark UST interest rate to its 25-year average
  • Municipal bonds historically less responsive to Fed interest rate moves

2014’s stellar performance in virtually all fixed income security classes will likely be the central story in most strategists’ “first half analyses.”  Stubbornly low rates across the yield curve continue to confound investors. Bearish predictions for the fixed income markets could accelerate if the economic data strengthen into the second half of the year.  At least a correction, if not an outright reversal, is in order, given the impressive 40 bp decline in the benchmark UST 10-year yield from 3.00% at year-end, and yields have moved higher in June.  However, in our view, some of the attention-grabbing headlines suggesting total return losses for bond investors might be a bit misleading.  Under certain circumstances, investors could realize positive total returns on their fixed income holdings even when measured during a period when yields are rising.

In order to gauge the potential impact of an interest rate hike on a fixed income portfolio’s performance, not only does the amount of the rate move have to be ascertained, but the timing and duration must also be quantified.  For example, a 100 bp (1%) yield increase over a very short time period (e.g., one year) on a portfolio could result in a negative total return.  However, if the rate rise is spread out over a longer timeframe, say two years (50 bp per year), or even three years (33 bp per year), the impact of the rate shock on performance is reduced accordingly.  Meanwhile, the bond owner is still receiving the same payment of coupon income regardless of the size of the interest rate move. Coupon payments can more than compensate for the loss in market value, which would then result in a positive total return, though the total return would be lower than under a falling interest rate scenario.

In summary, investors should not necessarily jump to the conclusion that rising interest rates automatically result in negative total returns. The timing of the interest rate move in addition to its magnitude determines the impact. Rational investors understand that in some years rates will rise; however, they also should appreciate the offsetting positive impact provided by the consistent income payments provided by these coupon-bearing bonds. The amount of the off-set is dependent on timing.

Over the past 25 years, the benchmark 10-year UST Note yield has averaged 5.14%.  A reversion to the mean is approximately 2.50% from its current rate level.  We think a move of this magnitude is very unlikely given the low level of inflation, stretched equity valuations, uneven global economic recoveries, and sustained demand for long-term Treasuries by pensions, insurers and an aging population.

Historically, long-term high grade taxable bond yields are not as sensitive to moves in the Federal Funds rate as shorter maturities.  Long-term municipals are even less responsive than taxable bonds according to Barclays’ data covering the five Fed rate hike periods dating back to April 1983. If the Fed decides to raise short-term rates, past experience suggests an even more muted reaction in municipal bond yields. 

Municipal Bond Insurance – The Revival of an Industry

The municipal bond insurance industry is in the early stages of a promising comeback from the dark days of the financial crisis, when losses on mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) nearly destroyed the business.  A number of well-publicized adverse credit developments, including those related to Puerto Rico and Detroit, have spurred investor concerns about the potential for municipal bond defaults in their portfolios and increased demand for protection.

Improved volume and pricing prospects for the industry, as well as strengthened balance sheets, have recently been reflected in credit rating upgrades for two of the industry’s former stalwarts, National Public Finance Guaranty (NPFG) - MBIA’s new insurance subsidiary - and Assured Guaranty - the only insurer that continued to write new business through the financial crisis. The ratings on NPFG were recently increased by S&P to AA- from A and by Moody’s to A3 from Baa1. The S&P rating on Assured Guaranty was raised to AA from AA-. The third, and the newest insurer, Build American Mutual (BAM), is rated AA by S&P.

Reflecting the improved outlook for the industry, we believe that bonds insured by the above-mentioned companies are solid investment-quality credits that have the potential to appreciate in value relative to uninsured bonds over the next two to three years, all other factors held constant.  There are two key reasons for this. First, assuming that interest rates will rise during this period, municipal bond issuers are expected to use increasing amounts of bond insurance to lower their borrowing costs on new issues. In turn, as the volume of insured paper increases, we expect an improvement in the overall liquidity of and investor demand for insured paper to follow. Second, as insured penetration increases and higher interest rates facilitate insurance premium hikes, business prospects for the insurers will improve, leading to stronger balance sheets and an upward migration of insurer credit ratings. As insurer credit ratings improve, so should the value of the bonds that they insure. Given our positive outlook for the industry, we are selectively purchasing insured bonds for client portfolios.

Submitted by the portfolio management team at SMC FIM

WWW.SMCFixedincome.com

Disclosures

The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management (“SMC FIM”), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.

This commentary does not constitute an offer to sell or a solicitation of an offer to purchase securities, or any other product sponsored or advised by SMC FIM or its affiliates, nor does it constitute an offer or a solicitation to otherwise provide investment advisory services. It should not be assumed that any of the security transactions listed were or will prove to be profitable, or that the investment recommendations we make in the future will be profitable.

Statements contained in this commentary that are not historic facts are based on current expectations, estimates, projections, opinions and beliefs of SMC FIM. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon. Unless specified, any views reflected herein are those of SMC FIM and are subject to change without notice. SMC FIM is not under any obligation to update or keep current the information contained herein.

This commentary does not take into account any particular investor’s investment objectives or tolerance for risk. The information contained in this commentary is presented solely with respect to the date of its preparation, or as of such earlier date specified in it, and may be changed or updated at any time without notice to any of the recipients of it (whether or not some other recipients receive changes or updates to the information in it).

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