INSIGHTS

On April 23, 2012

Rising Rates? Why Municipal Bonds May Weather the Storm

A rising interest rate environment over the next few years is an investment scenario to which many investors now subscribe. The prospect of rising rates often prompts investors to think along the following lines: “Interest rates are going rise and that’s bad for bonds, so I’ve got to cut back or stay away completely.” But what if we suggested that investment grade, intermediate municipal bonds (“muni’s”) might weather a rising rate storm comparatively well? We can’t issue guarantees on such a scenario, of course, but we do believe there are a number of factors worth considering that could help municipal bonds lessen the negative impact of generally rising interest rates.

Consider the following forces currently working or likely to appear in the near future:

• Demand for municipal bonds has grown since last year and is remaining strong. Reasons for this demand include increasing investor comfort with resilient municipal bond credit quality and the growing realization that municipal bond yields simply continue to make sense for top tax bracket investors given conservative alternatives available.

• Demand for municipal bonds may continue to be strong as investors seek to avoid higher tax rates that could come down the road.

• Supply of new issue municipal bonds, while above last year’s low levels, may come in below expectations as many issuers plan modest bond issuance for new projects. Many of these issuers are still in the mode of getting their fiscal house in order by constraining debt issuance among other measures. Supply has been low enough in the past year and a half to reduce the total amount of municipal bonds outstanding.

• Credit spreads among municipal bonds have become smaller in the past few months and could continue that trend given the gradually improving municipal bond credit quality we expect to materialize over the next few years.

• Municipal bond yields often exhibit less volatility than Treasury bond yields. Treasuries tend to be more of a trading vehicle for many investors which can contribute to more volatility relative to muni’s. The tax-exempt nature of municipal bond yields also tends to result in smaller adjustments relative to fully taxable Treasury bonds.

We agree that a trend of higher interest rates over the next few years appears likely. If that occurs, we don’t suggest that investing in muni’s will reverse the laws of bond mathematics. But our first impulse when we hear investors voice the “interest rate are rising/ bonds are bad” line is to think, “Which rates are you talking about and what part of the bond market are you invested in?” We suggest digging deeper when thinking about the prospect of higher rates. We believe that the combination of muni-specific factors listed above may work together to help counteract, in some degree, the forces pushing rates higher. We suggest that investment grade, intermediate municipal bonds may behave comparatively well among fixed income sectors in a challenging bond environment.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.