Should You Own Longer Duration Bonds In A Rising Rate Environment? by Catherine Stienstra, Columbia Threadneedle Investments
- In the next Fed tightening cycle, another “bear flattener” may occur, during which short rates increase and long rates either decline or rise less than short rates.
- Such a bear flattener is likely to result in long muni bonds outperforming shorter bonds.
- Investing in longer duration bonds in a rising rate environment may be beneficial, as investors would earn not only the higher yield longer bonds deliver, but also have the potential for greater price appreciation.
Long maturity municipal bonds have performed well
The benefits of investing in long maturity muni mutual funds in the low and declining interest rate environment of recent years are well known: Earn an attractive tax-free income in a high tax environment while receiving an added boost to your fund’s NAV. The cost of being short has been particularly painful for investors sitting on cash in recent years, as long muni bonds have produced strong returns. The question of the day is whether it still makes sense to invest in long muni bonds when many believe the Fed is on the verge of implementing a tightening policy, thereby leading to higher rates and lower bond prices.
Potential interest rate bear flattener beneficial to long bond investments
Yield curve positioning matters in this phase of the rate cycle when Treasury yields are expected to rise. The 2004-2006 Fed tightening cycle was a time of slow, steady and anticipated 25 basis points (bps) hikes, which eventually totaled 425 bps. During this period, the muni curve ‘bear flattened’, as yields on short bonds increased while yields on long bonds declined. As a result, long municipals significantly outperformed shorter bonds and munis outperformed Treasuries. The yield of the one-year AAA muni bond increased 210 bps while the yield on maturities 22 years and longer actually decreased 40 bps (Exhibit 1). Shifting to the current rate environment, we see the Fed once again being very deliberate in communicating its intent, this time to move off its historic ZIRP (Zero Interest Rate Policy) and back to normalizing rates. While there is intense focus on when the Fed will move, the outcome for investors is not expected to be materially different whether the hikes begin in October, December or 2016.
While many investors are fearful that rates will rise across the curve, it is possible that another bear flattener transpires, during which short rates increase and long rates either decline or rise less than short rates. Such a flattener is likely to result in long muni bonds outperforming shorter bonds. Therefore and contrary to current conventional wisdom, investing in longer duration bonds in a rising rate environment may be beneficial, as investors would earn not only the higher yield longer bonds deliver, but also have the potential for greater price appreciation.
Exhibit 1: Impact of Federal Reserve tightening policy
AAA Municipal Bond Yield Curve (6/30/04 and 6/30/06)
Fed funds rate increased from 1.00% to 5.25%. The short end of muni curve rose. The long end declined.
Source: Barclays, 09/30/15
Past performance does not guarantee future results.
Historically, the long end of the muni curve tends to underperform the shorter end in the months leading up to the tightening due to increased volatility – which is what has happened in the muni market year-to-date. From the start of this year, yields on 30-year AAA-rated muni bonds rose by nearly 75 bps through the end of June. However, since then, yields on the same maturities have fallen by approximately 35 bps and are now higher by roughly 40 bps, as the volatility in other asset classes caused investors to seek the relative safety of municipal bonds. Typically, once the Fed begins to tighten, munis outperform as investors seek the higher yields provided by longer dated munis, a result of the volatility/sell-off preceding the tightening (Exhibit 2). As such, this increased demand typically results in muni/Treasury yield ratios soon returning to more historical levels.
Exhibit 2: Opportunity cost of staying short in Fed tightening cycle
Total Return of Municipal Bond Indexes (calendar year performance)
Long muni bonds outperformed during 2004–2006 rate hikes
Source: Barclays, 08/31/15. Barclays Municipal Bond Indices: 3-year index (2–4 years), 10-year index (8–12 years), long bond (22+ years).
Past performance does not guarantee future results.
Looking again at the 2004-2006 Fed tightening period, investors in the long-end of the muni market outperformed the short end by approximately 480 bps. In other words, yield curve positioning was a source of significant outperformance for those invested in longer-dated securities.
Current market environment is supportive of long muni bonds
Clearly, there is no guarantee that history will repeat itself as the long-end of the muni curve is affected by a variety of factors including economic growth expectations, inflation pressure and supply/demand dynamics. One difference between then and now is the starting point of the rate hikes. With the 2004-2006 cycle starting at 1.25% and today at 0.0%, a lower starting point leaves less cushion in a rising rate environment. However, it is possible that a muni bear flattener is the most likely outcome and will benefit longer-dated bonds relative to shorter bonds for the following reasons:
Economic growth — it is too early to fully understand how the slowdown in China will impact growth in the U.S. At this point, we are anticipating a continued slow, gradual increase in the growth of the U.S. economy, not a markedly higher growth pattern which would drive inflation and interest rates higher.
Inflation – our expectation for inflation is relatively muted, which is likely to relieve pressure on the long-end of the curve and limit any increase in long yields for the near-medium term. The September 17 FOMC meeting reinforced this expectation, as they voted to maintain the current ZIRP monetary policy due to a lack of inflationary pressure and pushed out hitting its 2% inflation goal to 2018. Note that if there is an unexpected jump in inflation, it will largely be at the expense of longer bonds.
Supply technicals — on the supply side, the new issue calendar is higher than in the same period a year ago but has been dominated by refundings (refinancings) which has, essentially, pulled forward longer-dated supply. This scarcity of longer-dated supply may lead to outperformance of the long end vs. the short end, as investors chase a declining supply of long bonds.
Demand technicals — demand from retail investors is likely to remain positive as income from muni bonds are one of the few investments exempt from our high and increasing tax rates. In addition, it is possible that once the uncertainty about the imminent Fed move dissipates, a large amount of cash that has been sidelined for the last few years will be invested in the longer end of the yield curve.
Investing in munis over the long term has been profitable
Keep in mind that investing in longer duration muni funds is most appropriate for investors with a longer-term investment horizon. Using the Barclays Municipal Bond Index as a proxy for the broad municipal market, one can see that over the last 30 plus years, the muni market produced negative returns in only four years (Exhibit 3). Negative years were generally followed by positive years, leaving the two-year trailing total return negative only once and, even then, for a period of less than two months. For long-term muni investors, investing can pay off, even in a rising rate environment.
Exhibit 3: Barclays Municipal Bond Index (calendar year returns)
Only four negative years since 1984.
Source: Barclays, 08/13/15
Past performance does not guarantee future results.
