INSIGHTS

On December 02, 2016

Municipal Yields Revisit November 2015 Highs

By now, it should be no surprise that President-elect Donald Trump’s pro-growth and reflationary fiscal policies have caused great stress on the fixed income universe. The municipal bond asset class, typically where investors flock toward during times of volatility, has been unable to differentiate itself from other fixed income classes and mitigate the losses sustained from this rapid rise in interest rates. In fact, through November 21, the broad Barclays Municipal Bond Index, with a month-to-date loss of -2.66%, is underperforming the -2.35% month-to-date return of the Barclays U.S. Aggregate Bond Index. Bond prices eroded and yields widened more than 60 basis points in the 10 trading days after election day as municipal investors have struggled to find stability in a volatile market that is currently attempting to price in all of the speculated tax cuts, inflation, and unprecedented fiscal stimulus that President-elect Trump has promised to bring to “make America great again.” While losses like these are never easy to digest, especially when most retired or soon-to-be-retired citizens have a sizable portion of their wealth invested in municipal bonds, it is absolutely essential to remember the purpose of an allocation to municipals and perhaps incorporate a macro perspective of where municipal yields have been beyond the last three weeks (or three months for that matter).

First off, long-term investors should think back and recall when the markets last saw interest rates within this range. Believe it or not, it was exactly one year ago: November 2015. Keep in mind that at that point in time investors and markets alike were waiting all year long for the Fed to raise the federal funds rate from its rock bottom level of 0—0.25%. With the December 2015 Committee meeting as a last resort option for the Fed to take action, yields rose slightly to adjust forth rate hike. The 10-year AAA municipal benchmark recorded a 2.19% yield during the middle of the month, which was not too far from today’s 10-year yield of 2.30% (Note: going a little further back, June 2015 actually produced the highest yields of last year with 10-year yields as high as 2.38%). However, (with 20/20 hindsight) even with all the ingredients in place for a rising rate environment from the official 25 basis point increase and an additional four hikes forecasted for next year, the markets handed investors a major plot twist in the form of much lower yields throughout the majority of 2016.

Municipals certainly experienced a rather violent turnaround since record low yields of 1.29% and 1.93% were recorded for the respective 10- and 30-year benchmarks following the Brexit vote in early July. Although the painful reversal of rates from this “Trump Tantrum” has been both painful and shocking for all involved, there have been several signs indicating such a move was expected or even imminent. Despite the massive selloff within this short period, current yields are still well below their 10-year averages. The 10-year municipal has averaged a 2.73% yield at year-end since 2006, which is still almost 50 basis points higher than where AAA bonds are trading in this market. Over the last 3+ years, numerous municipal strategists, portfolio managers, and even retail investors have seriously anticipated and devotedly warned against rising rates. If municipal portfolios were managed and positioned for such a rising rate scenario at any point during this three-year span, the losses sustained since Election Day should have been mitigated to an extent. In essence, while timing higher interest rates is a near impossible feat, preparing your portfolio for them is not.

It was not too long ago that the consensus view saw interest rates staying “lower for longer” based on continued modest U.S. economic growth as well as accommodative/negative rate policies across global banks. This view now appears to be for the contrarian investor. For those fearful of prolonged negative returns to their municipal portfolios, there is one broad scenario that could potentially halt or even reverse the losses: higher interest rates generally lead to reduced new money supply and issuer refunding deals, which in turn, should stabilize and perhaps boost investor demand for municipals (given all other things equal). Outside of municipal supply/demand dynamics, the trend of rising Treasury yields (which are typically shadowed by municipals) will be highly dependent on several macro events playing out a certain way in 2017. What if any of these events turn out differently? Could the U.S. economy suffer a housing or employment setback and give the Fed reason to return to accommodative policies? Could there be another risk-off selloff caused by a China slowdown or another Brexit-like event in the coming year? Could the Trump administration fall short on their campaign promises and fail to “make America great again”?

Whether these various events bring about further prosperity or turmoil to markets, we believe investors making emotional or drastic changes to their municipal portfolios in response to volatile movements could actually do more harm than good to their long-term investment goals.

CRN: 2016-1201-5659R

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.