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Municipal Bonds

Municipal market: How rates rise matters

Christopher G. Barron
Client Portfolio Manager
subway stairwell

Some investors are concerned that continued accommodative monetary policy will help stoke inflation and eventually cause bond yields to increase. Since rates and bond prices are inversely related, investors continue to evaluate their fixed income allocations. Some favor a shorter duration profile due to concerns over bond yields eventually rising (duration measures price sensitivity to changes in bond yields). Others see an opportunity to lengthen portfolios, given less concern about rising bond yields and more attractive relative yields further out along the yield curve. Which approach is right?

An analysis of historical changes in monetary policy – specifically the fed funds rate – shows that various areas of the municipal yield curve responded differently depending on economic conditions, the shape of the curve moving into the tightening cycle and the manner in which the Fed tightened. It also shows that the short end of the curve wasn’t necessarily the least risky, nor was the longest the most volatile. Finally, it shows that in these rising rate environments, a hypothetical investor who stayed the course through the tightening cycle – regardless of their position on the yield curve – may have experienced positive total returns, the notion that “rising rates are bad for bond investors” notwithstanding.

Prior tightening cycles: Setting the stage

To simplify the analysis, a rising rate period is when the Federal Reserve is tightening. This means that short-term rates are rising, but other factors may be impacting the intermediate and long ends of the yield curve. Since 1994, there have been four periods of increasing fed funds rates, as detailed in Figure 1.

Figure 1: Changes in fed funds rates

Tightening effect vastly different along the yield curve

Figures 2 thorough 5 detail the performance of the municipal bond market during the prior four tightening cycles. The indexes represent different areas of the municipal yield curve. It illustrates how these maturities responded to changes in the fed funds rate during four segments of each tightening period: 

In each period, bond yields increased on the short end of the yield curve as the Fed raised short-term rates. However, there was less consistency in the impact on the other parts of the curve and in the performance of various maturities during and after the tightening cycle.

Figure 2: Returns along the yield curve – period 1 (4 Feb 1994 to 1 Feb 1995)

The Fed was hawkish during this cycle, given stronger economic growth prospects and inflation expectations. Individual Fed fund increases ranged from 25 basis points (bps) to 75 bps, generating volatility across the fixed income markets. The yield curve flattened by 76 bps and the best cumulative performer across all three periods came from the Bloomberg Barclays 10-Year Municipal Index (8-12 years).

Figure 3: Returns along the yield curve – period 2 (30 Jun 1999 to 16 May 2000)

Mid-1999 could be characterized by economic exuberance and robust growth prospects. As in the prior period, there were instances where individual rate increases exceeded 25 bps. The yield curve flattened by 17 bps and the best cumulative performer across all three periods was the Bloomberg Barclays 1-Year Municipal Index (1-2 years).

Figure 4: Returns along the yield curve – period 3 (30 Jun 2004 to 29 Jun 2006)

This cycle was the most transparent in terms of Fed guidance and market expectations. All rate increases were 25 bps, implemented at a deliberate and measured pace. The yield curve flattened by 235 bps and the best performer across all time periods was the Bloomberg Barclays 22+ Municipal Index.

Figure 5: Returns along the yield curve – period 4 (15 Dec 2015 to 19 Dec 2018)

This cycle saw a gradual normalization of monetary policy, with 9 rate increases over 36 months. The yield curve flattened, with shorter bond yields increasing and longer bond yields decreasing. All six municipal benchmarks generated positive returns, with the Bloomberg Barclays 22+ Municipal Index performing best. Figure 6 summarizes the market characteristics and outcomes of the four tightening cycles.

Figure 6: Market characteristics of each period of rising rates

Observations across tightening periods

 

Staying the course can benefit investors

Armed with this historical analysis, how should investors move forward? Successful market timing is difficult, if not impossible. Investors sometimes sell following a sharp price decline, hoping to reinvest as the market recovers. But analysis of five periods of municipal market volatility suggests that investors who stay the course can benefit from their patience.

Valuations recovered within one year

We analyzed five periods where municipal yields “spiked,” meaning they increased by at least 100 basis points in less than one year. We examined the total return of hypothetical $100,000 portfolios held for 3-, 6-, and 12-month periods following the spike. While the portfolios experienced volatility, staying the course was ultimately rewarded.

Within one year of each spike, cheap valuations led to increased investor demand and valuations became more in line with historical averages.

Period 1: September/October 2008

Trigger: Market liquidity evaporated following the Lehman Brothers bankruptcy.

Yields increased across most credit instruments. Notably, intermediate- and longer-term maturities experienced the largest yield increases and the sharpest declines in value.

 
Figure 7: Capital preserved and grown within 12 months of the yield spike

Period 2: October 2010 to January 2011

Trigger: Strong supply and an analyst’s prediction of an unprecedented uptick in defaults and bankruptcies.

The yield increases were similar to Period 1, except that weakness was spread across four months versus just five weeks. As yields peaked, long maturities saw the greatest decline.

Figure 8: Principal recouped within 6 months; principal growth within 12 months of the yield spike

Period 3: May 2013 to September 2013

Trigger: the taper tantrum combined with the Detroit bankruptcy filing and increasing attention on Puerto Rico.

Figure 9: Principal recovered within 12 months of the yield spike

Period 4: July 2016 to December 2016

Trigger: Near-historic low yields following the summer BREXIT vote and the November U.S. election results.

With a Republican sweep, the market began pricing in a stronger likelihood of more growth-oriented policy/deficit financing, which helped pressure yields higher.

Figure 10: Principal was nearly recouped or experienced modest principal growth

Period 5: March 2020

Trigger: Concern over the coronavirus pandemic caused municipal yields to increase nearly 200 bps over a three-week period.

As investors sought to raise cash for liquidity purposes, this period saw the most severe absolute yield increases.

Figure 11: After three months, shorter maturities nearly recouped or experienced modest principal growth

Portfolios were eventually compensated for patience

In times of elevated market volatility or negative press, investors may decide to sell and wait for conditions or valuations to improve before reallocating funds. But most cannot time the market perfectly, which can mean lost opportunity.

Figure 12 shows that missing even the first two weeks of a market rebound resulted in lower portfolio values. In all periods, portfolios were eventually compensated for patience.

For an initial hypothetical investment of $100,000, in each period:

Figure 12: Staying invested led to higher returns

Rising rates aren't always bad for municipal bond investors

Investors have access to more information and advice than ever before. It’s sometimes difficult to separate high quality, long-term investment advice from knee-jerk trading suggestions.

Sharply rising rates can cause concern, as investor sentiment deteriorates and portfolios lose value more quickly. Nuveen does not anticipate a sharp rise in rates in the coming months, nor do we expect the Fed to push rates dramatically higher. Rather, we believe investors should understand that periods of rising rates do not necessarily correlate to losses in bond portfolios, and that attempting to time markets can have negative impact. In each of the last five municipal market rate spikes, staying the course was eventually rewarded.

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Endnotes
1 Data source: Bureau of Economic Analysis
2 Data source: Bureau of Labor Statistics

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

A word on risk
IInvesting involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.

This information should not replace an investor’s consultation with a financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax advisor regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

Nuveen Asset Management, LLC manages strategies that may invest in bonds. This material is not intended for use in the promotion or sale of any mutual fund, closed-end fund or other Nuveen investment product.

Nuveen provides investment advisory solutions through its investment specialists.

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