Fed Rate Hikes Don’t Have To Be A Roadblock For Municipal Bonds by Daryl Clements and Matthew Norton, AllianceBernstein
Strong US economic growth is paving the way for the Fed to raise interest rates—and some municipal bond investors are afraid their bond portfolios will be wrecked. We think those fears are unfounded.

Investors buy municipal bonds for safe, tax-exempt income. It’s natural to worry about what will happen to that stability if rates start climbing. But fear shouldn’t trump facts: in the past five Fed tightening cycles, rates rose, but munis still provided positive returns.

How Might Rising Rates Impact Munis?

But what will happen this time around? Of course there are no guarantees, but running the numbers can give us a pretty good assessment of what could happen (Display).

municipal bonds
Municipal Bonds

Let’s assume the market gets exactly what it expects over the next three years. Based on today’s yield curve, the federal funds rate would rise to about 2% by 2018. Let’s also say short-term rates rise more than longer-term rates. In other words, the yield curve reverts to a more normal shape.

The numbers in the market scenario show that over a three-year time frame, all muni returns are positive in annualized terms. Intermediate-term and long-term bonds outperform shorter-term bonds. That’s to be expected with short-term rates rising the most.

What may surprise some is that A-rated and BBB-rated bonds outperform AAA bonds. One of the advantages of BBB-rated bonds is the added yield they provide, because investors shoulder more credit risk.

Is There Risk in the Event of a More Aggressive Rate Hike?

What happens if the market is wrong and the Fed raises rates more aggressively as the economy accelerates?

We looked at that scenario too, using the median forecast for the fed funds rate from Federal Open Market Committee members. This forecast implies that the rate will rise to 3.4% by the end of 2018. (Clearly, the Fed and the market are speaking two different languages!)

Keeping the assumption of a normally sloped yield curve, almost all annualized bond returns are still positive in the aggressive Fed scenario—a scenario we believe is unlikely to materialize. Bonds with 15- and 30-year AAA maturities show slightly negative returns, but A and BBB bonds are slightly positive.

Wait—How Can Returns Be Positive After a Large Rate Hike?

Muni returns remain mostly positive in these examples because time heals bond portfolios.

Sure, bond prices decline as rates rise, but yields rise, too. And yield, along with the return from roll—the natural price gain of a bond as it moves closer to maturity—will more than offset any price declines. That said, investors should expect some months when bond returns will be negative.

Yield-Curve Positioning Matters

Maturity structure is an important aspect of portfolio construction. There are better and worse ways to structure a bond portfolio in today’s market environment. When the fed funds rate finally goes up, yields won’t feel the same effect at every bond maturity.

In the more likely market scenario, municipal bonds with 15- and 30-year maturities have the highest returns, but we don’t suggest that investors buy only longer-maturity bonds. They should own fewer short-maturity bonds because they’re likely to underperform intermediate- and long-maturity bonds in a rising rate environment.

When the Fed does increase rates, bond returns will not be crushed, as some investors fear. We believe that at the end of the day, municipal bonds will continue to provide the stability and income that investors rely on.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.