Municipal Bonds: Rising Rates in a Highly Nuanced Market

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1 INSIGHTS & PERSPECTIVES From MacKay Municipal Managers Municipal Bonds: Rising Rates in a Highly Nuanced Market MacKay Municipal Managers believes that prudent, active managers can continue to extract returns from the municipal market, even in a rising interest rate environment. In addition, we believe that an actively managed, relative value driven approach to generating total return in the municipal bond market is not limited by the direction of rates and, in our view, can benefit from market environments where volatility increases. In this document, we review our assessment of how municipal investors typically approach the prospect of higher rates and provide our view on how they should think about the impact of higher yields. Municipal bond investors are likely to lower their return expectations when anticipating rising rates. After all, investors understand that when yields rise, bond prices fall. However, the average municipal bond investor may struggle to properly estimate the scale of the impact of rising rates. In our opinion, many municipal bond investors likely overestimate the expected losses due to rising rates. In addition, most municipal bond investors tend to focus only on the price return component of total return, rather than thinking of total return as including both price change and income earned. Prior to a discussion on the impact of rising rates in the municipal bond market, a review of bond return measurement is essential. We believe municipal investors, even those investors who claim to only be concerned about their income, should focus on the total return of their municipal investments. Total return is the sum of a bond s income return and price return over a given period of time. For a fixed-rate coupon bond, the expected income earned is known and steady, while the price return will likely fluctuate due to different factors. Time horizon is an important factor to consider when thinking about the potential of rising rates. Investors often focus on when interest rates will rise, in an effort to time the market. However, they may be better served by thinking about how much they rise and how long it will take. For example, is the expectation for rates to rise sharply over a short period of time or for a more gradual increase over a longer period of time? While forecasting precise interest rate moves is fraught with error, developing an expectation of general rate trends using information, such as economic growth conditions, is reasonable. Time is a benefit for the owner of a fixed-rate bond because of the accrual of income over time. For example, in the scenario of a gradual rise in yields over a longer period of time, the significance of the income component of return rises. Likewise, over short periods of time, a rate increase can be distressful to an investor if the investor ignores the income that is accruing. The bonds comprising the municipal market rarely move in unison. The municipal market may be thought of as an array of bond maturities stretching out to over 30 years. In most market conditions, the yields on bonds increase as maturity lengthens. A line chart, called a yield curve, will typically be upward sloping from left to right to represent this relationship. When the media makes reference to rates rising, the conclusion could be that the yields of all maturities shift by the same amount, which is referred to as a parallel shift in the yield curve. However, bond yields rarely move this way. Instead, various factors impacting the different maturity segments of the

2 market can result in non-parallel shifts, often leading to either a flattening or a steepening of the yield curve. Therefore, a well-reasoned expectation of how rates will behave on a relative basis along the yield curve can point to a preferred curve placement strategy that may result in potentially better returns. For example, during the last Fed tightening cycle from 2004 to 2006, the yield curve flattened, and long-maturity and high yield municipal bonds experienced strong returns. The following charts illustrate this example. Municipal Bonds Performed Well During the Last Fed Tightening Cycle Long-maturity and high yield municipals experienced strong returns during the last Fed tightening cycle Figure 1: Municipal AAA Yield Curve (June 2004 June 2006) 1 Source: Bloomberg, US Muni GO AAA Yield Curve Figure 2: Breaking Down Return Components across the Municipal Market (Cumulative Returns: June 2004 June 2006) Source: Barclays, as of 5/31/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Bloomberg Barclays Capital 1-5 Year Municipal Bond Index measures the performance of municipal bonds with time to maturity of more than one year and less than five years. Bloomberg Barclays Municipal Intermediate (5-10 Year) Bond Index: Is an unmanaged index of long-term, fixed-rate, investment-grade, tax-exempt bonds representative of the municipal bond market. The Bloomberg Barclays 5-Year Municipal Bond Index is the 5-year (4-6) component of the Bloomberg Barclays Municipal Bond Index. Bloomberg Barclays 7-Year Municipal Bond Index is an unmanaged index of municipal bonds issued after January 1, 1991 with a minimum credit rating of at least Baa, been issued as part of a deal of at least $50 million, have a maturity value of at least $5 million and a maturity range of 4-6 years. As of January 1996, the index also includes zero coupon bonds and bonds subject to the Alternative Minimum Tax with maturities between nine and twelve years. The Bloomberg Barclays 10-Year Municipal Bond Index is the 10-Year total return subset of the Bloomberg Barclays Municipal Bond Index. Bloomberg Barclays Capital Long-Term Municipal Bond Index is composed of those securities included in the Bloomberg Barclays Capital Municipal Bond Index that have maturities greater than 22 years. The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment-grade tax-exempt bonds with a maturity of at least one year. Bonds subject to the alternative minimum tax or with floating or zero coupons are excluded. Bloomberg Barclays Municipal High Yield Index is an unmanaged index consisting of non-investment grade, unrated or below Ba1 bonds. 2

3 Municipal bond yields rarely move in lock-step with Treasury bond yields. The context for virtually all media references to interest rate changes is the Federal Reserve s Federal Funds Target Rate Range and the U.S. Treasury bond market. Municipal yields, however, tend to not move precisely in line with Treasury yields, typically moving less, and the relationship of the relative rate moves can vary along the yield curve based on factors such as supply and demand, investor behavior, and relative value. Therefore, when rates are rising in the Treasury bond market, they are likely rising in the municipal bond market, but to a lesser degree, resulting in more muted price changes. In our opinion, investors should adjust their rising municipal rate expectations downward from the increase expected in Treasury bond yields, depending on the maturities of the bonds owned and current market conditions. Municipal Bond Returns Are Typically Less Correlated with the Treasury Market Figure 3: 10-Year Correlation with Bloomberg Barclays US Treasury 7-10 Year Index (as of April 2017) Bloomberg Barclays Municipal Intermediate 5-10 Year Index is an unmanaged index that measures the performance of municipal bonds with time to maturity of more than five years and less than ten years. Bloomberg Barclays 1-3 Year Municipal Bond Index consists of a broad selection of investment grade general obligation and revenue bonds of maturities ranging from one year to four years. Bloomberg Barclays Municipal Bond Index covers the USD-denominated long term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds. Bloomberg Barclays Municipal Long 22+ Year Index is an unmanaged index that measures the performance of municipal bonds with time to maturity of no less than 22 years. Bloomberg Barclays Municipal High Yield Index is an unmanaged index consisting of non-investment grade, unrated or below Ba1 bonds. Source: Morningstar Direct The structure of a municipal bond can also impact its sensitivity to changes in interest rates. Typically, a bond s price sensitivity to rate changes is summarized in a single value called duration. Duration is impacted, mathematically, by a bond s structural features coupon, maturity date, call date and price. In addition, market preference for specific structures can result in relative value differentials that also either amplify or mitigate the impact of rising rates. Therefore, when building a portfolio, it is prudent to consider a bond s structural features and the potential impact they may have on a bond s relative performance in a rising rate environment. Credit quality of a municipal bond can also impact its sensitivity to interest rate changes. As a general rule, when assessing municipal bonds ranked by credit rating, as the credit rating declines, so does the bond s sensitivity to interest rate movements. Essentially, a 3

4 more credit-sensitive bond tends to trade more on its credit fundamentals than on its interest rate sensitivity characteristics. Therefore, when credit spreads are attractive, an overweight exposure to credit sensitive bonds can further manage the impact of rising interest rates. Rising interest rates may coincide with an improvement in municipal credit quality. For example, improving economic conditions may lead to higher inflation expectations, which, in turn, are reflected in higher interest rates. In such situations, for many municipal issuers, the impact of stronger economic conditions is readily observed as tax and fee revenues rise, interest rate coverage improves and fundamental credit conditions strengthen. This economic growth can ultimately lead to credit upgrades and potentially result in a municipal bond s price falling less or even improving as interest rates are rising. The advance refunding option, a feature unique to the municipal bond market, is currently dependent on rising interest rates. In an advance refunding, a municipal issuer defeases its debt obligation by replacing its promise to pay the bonds with an escrow account typically holding an array of U.S. Treasury securities. The escrow is typically designed to retire the defeased municipal bond at the first call date, essentially replacing the longer-term maturity with a new shorter-term maturity. The defeasement to the call date and the underlying credit quality of the escrow usually result in a significant price increase for the advance refunded bond. Currently, for the economics of the escrow to work, Treasury bond yields need to be higher than current municipal yields in order to cover the higher-yielding, older municipal bonds that are eligible to be refunded. Therefore, rising Treasury bond yields can result in municipal bonds being advance refunded and holders of those bonds experiencing significant price increases. Active management of a municipal bond portfolio can also potentially contribute to total return. The fractured nature of the municipal bond market, in conjunction with poor disclosure and heavy ownership by individual investors, contributes to its inefficiency. As a result of this inefficiency, municipal bond pricing often creates relative value opportunities that are recognized and exploited by professional, active municipal bond managers. In addition, the prevalence of individual investors in the municipal market creates additional inefficiencies because of the spread between what institutions pay for bonds versus what individuals pay. Since 2008, these spreads have become quite wide. As a result, active managers can often exploit these wide spreads by buying bonds at institutional prices and then selling them to individual investors at much higher levels. What is notable about these opportunities is that they are not necessarily dependent on the movement of rates. Active management can potentially produce returns that offset the impact of a rising rate market. At MacKay Municipal Managers, we have been cautious about the potential for rising rates for some time now and believe we are prepared and able to navigate this rising rate environment. 4

5 When we think about the potential for rising rates today, we believe the following: 1. That we will likely see rates increase at a gradual pace over time. Therefore income to be earned is an important component of estimating expected total return. 2. We believe that municipal bond yields will follow their historic pattern of rising less than yields on comparable maturity Treasury bonds. As a result, we expect a more tempered impact in the municipal market. 3. We believe that shorter-term yields should rise more than longer-term yields leading to a flatter municipal yield curve. We are positioned to specifically avoid the four- to 10-year segment of the municipal market because we believe it will underperform in a flattening yield curve environment. Recently, we have favored bonds maturing between 10 and 25 years. 4. We believe that owning premium coupon, callable bonds in the 10- to 25-year segment of the curve will provide a further cushion, in the shorter run, against unexpected upward spikes in rates. 5. We continue to view credit spreads for mediumto-lower investment-grade bonds to be attractive because we expect them to tighten over time as credit fundamentals improve with economic growth. As a result, we have maintained overweight exposures to credit because we expect those bonds to show a lesser degree of sensitivity to upward rate movement. In addition, we believe that credit spread tightening will further mitigate the negative impact of rising rates. 6. We may use interest rate hedges to keep portfolio durations in line with benchmarks, even as we overweight exposure to the 10- to 25-year segment of the yield curve. 7. At this inflection point in the direction of interest rates, we believe market uncertainty will rise and, therefore, result in more periods of volatility. We believe that this volatility further enhances our ability to identify mispriced security opportunities in the market and generate additional alpha. 8. We find opportunities to exploit the difference between institutional and retail markets on an almost daily basis. For example, we can buy bonds wrapped by newer bond insurers at very cheap institutional levels because institutions assign minimal value to the insurance policy. However, individual investors may lack the ability to conduct credit research and, therefore, generally assign a much higher value to the same insured bonds. We engage in that trade virtually every trading day, regardless of the direction of rates. 9. Since our arrival at MacKay in 2009, we have focused on buying bonds, when all other conditions are equal that have the opportunity to be advance refunded. Our objective was to build up holdings in securities that would, when rates rose, become advance refunded and produce positive price returns. Conclusion Fixed-income instruments are not all created equal in terms of their interest rate sensitivity. Given the unique nuances and characteristics of the municipal bond market, several factors come into play when assessing the impact of rising rates. Skilled active managers are well positioned to navigate, and even capitalize on, today s interest rate environment. 5

6 1. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The yield curve in this illustration is built using nonparametric fit of market data obtained from the Municipal Securities Rulemaking Board, new issues calendars, and other proprietary contributed prices. Regarding credit quality, the S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment-grade, while BB through D represent non-investment grade. Before you invest Mutual funds are subject to market risk and will fluctuate in value. A portion of a municipal fund s income may be subject to state and local taxes or the Alternative Minimum Tax. Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner. High yield securities (commonly referred to as junk bonds ) are generally considered speculative because they present a greater risk of loss than higher-quality debt securities and may be subject to greater price volatility. High yield municipal bonds may be subject to increased liquidity risk as compared to other high yield debt securities. Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes which could affect the market for and value of municipal securities. Such uncertainties could cause increased volatility in the municipal securities market and could negatively impact the Fund s net asset value and/or the distributions paid by the Fund. Securities purchased by the Fund that are liquid at the time of purchase may subsequently become illiquid due to events relating to the issuer of the securities, market events, economic conditions, or investor perceptions. Availability of this document and products and services provided by MacKay Shields may be limited by applicable laws and regulations in certain jurisdictions and this document is provided only for persons to whom this document and the products and services of MacKay Shields may otherwise lawfully be issued or made available. None of the products and services provided by MacKay Shields are offered to any person in any jurisdiction where such offering would be contrary to local law or regulation. This document is provided for information purposes only. It does not constitute investment advice and should not be construed as an offer to buy securities. The contents of this document have not been reviewed by any regulatory authority in any jurisdiction. 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