Yields on U.S. bonds in general have declined for more than 30 years. Multiple economic cycles, five recessions, and broad evolutions in trading and investing have taken a toll. Throughout this decline, there have been six periods of Federal Reserve (Fed) monetary policy tightening and several other periods when market yields rose meaningfully. While a rise in yields can benefit investors focused on income, the corresponding drops in price and underlying net asset value can be painful—a circumstance that has affected all bond investors since January 2022.
Thus far in 2022, capital markets can be characterized by extraordinary levels of volatility and reversal fueled by historic inflation globally. These fears have been intensified by the economic and humanitarian crises due to Russia’s war in Ukraine.
In the wake of these events, U.S. fixed income yields have risen sharply with the Fed’s increases in the federal funds rate (totaling 3.00% to date) in its effort to cool the rate of year-over-year increases in consumer prices. With a U.S. focus based on domestic revenues and tax collections, the municipal bond market typically has outperformed other fixed income asset classes in rising-rate environments marked by global volatility.
Rising rates have brought competitive returns for U.S. municipals
Periods of sharp negative returns across equity and fixed income asset classes can present unique opportunities for clients. These opportunities often can be found as investors seek to reallocate unbalanced portfolios and take advantage of tax-trading opportunities that allow losses to be booked and carried forward to offset future gains. From a historical perspective, when we examine the fixed income market during periods of rising rates, a number of themes have arisen. Specifically, the U.S. municipal market historically has consistently outperformed the broad bond market on both nominal and after-tax bases.
Bonds have two elements to total return: price return and income. As interest rates rise, bond prices fall, resulting in negative price returns. However, total returns may still be positive if the income over time surpasses the price declines. In rising-rate environments, income generally is reinvested at higher rates, which historically has in turn increased the overall total return.
The chart below shows that in eight of the nine rising-rate periods from January 1, 1983, to January 1, 2022, municipal bonds experienced positive total returns when adjusted for taxes (assuming a 28% federal tax bracket). In all nine rising-rate periods, municipal bonds outperformed the index’s total return. This was true despite the fact that municipal bonds experienced negative price returns in eight of the nine periods. Adjusting the income earned for the impact of taxes caused those eight periods to deliver positive total returns.
Why have municipal bonds outperformed?
U.S. municipal bonds’ historical outperformance relative to taxable bonds may be attributed to several factors:
- Municipal bonds have lower correlations to U.S. Treasuries and less interest rate sensitivity than corporate bonds.
- Compared with the corporate bond market, the municipal market is more diverse and less efficient and price discovery is more difficult.
- The majority of municipal bonds are held by retail investors who tend to buy and hold, and this tendency serves as an important stabilizing force.
Higher bond yields translate to lower bond prices. Like all U.S. fixed income, municipal bonds are interest rate sensitive and have positive correlation to the U.S. Treasury market. However, their correlation to Treasuries tends to be lower than other fixed income asset classes’ correlations are. As a result, while municipals’ yields/prices move in concert with Treasuries, they do so to a lesser degree than other fixed income asset classes.
The table below shows correlations between U.S. Treasury bonds, corporate bonds, the Bloomberg U.S. Aggregate Bond Index, and municipal bonds from August 31, 2002, to September 30, 2022.
An inefficient market
The U.S. municipal bond market was just over $4.3 trillion as of September 30, 2021—less than one-third the size of the more than $15 trillion corporate bond market. Even so, within the municipal market, there are roughly 5 times as many issuers and 30 times as many individual securities outstanding. This results in far less coverage from sell-side credit analysts in the municipal market and therefore less visibility into individual bond issues.
Trading in the municipal market differs from other bond markets. The municipal market doesn’t have dominant, standardized, electronic trading platforms like the ones supporting taxable corporate bonds and U.S. Treasuries. Trading in the municipal market is fragmented and done over the counter, which tends to reward large, active investors who have deep relationships in the municipal marketplace. Also, given the smaller average trade lots, the diversity of municipal line items, and the lack of recent trading for the vast majority of municipal securities, pricing is less apparent than in other markets.
The U.S. municipal bond market is viewed as having more retail ownership and more ownership by non-financially motivated actors than the corporate bond market. More than 43% of the municipal market is held by households or in private pensions and government retirement plans. Mutual funds, money market funds, closed-end funds, and exchange-traded funds (ETFs) account for another 29% of securities. Insurance companies—which may hold municipal bonds for diversification benefits and book yields—may be less motivated to sell bonds quickly in the face of rising yields. These investors account for 12% of the market.
All of the above owners may be characterized as buy-and-hold investors rather than speculators. As such, they’re typically less likely to sell in times of rising rates or lower bond prices. Municipal bonds typically are held as income-producing assets or as part of larger tax-mitigation strategies, so trading decisions tend to be less driven by the global-risk trading or regulatory purposes more often associated with Treasuries. This stabilizing force blunts the impact of rising rates on total returns in the municipal market.
Municipal bonds merit consideration in times of rising rates
Rather than passively investing in the municipal index and riding the full impact of rate increases, U.S. municipal bond investors may choose to employ strategies as rates rise that potentially limit downside price impacts and add to total returns.
Although different each time, certain patterns have emerged during periods of rising rates: Relative to the overall municipal bond index return, premium-structure bonds have outperformed, the yield curve has flattened, and credit has outperformed the overall benchmark. We expect these general themes to continue playing out throughout the rest of the current move to higher rates and to repeat in future cycles.
Investors looking to position their portfolios for higher rates may want to consider the following ideas:
- Duration: Positioning portfolios short relative to the respective benchmark may reduce volatility driven by rising interest rates. Strategies with wider bands of duration flexibility and/or managers with lower historical reliance on interest rate risk may prove beneficial.
- Curve: Structuring portfolios to take advantage of a curve-flattening environment may benefit returns. Because the curve tends to flatten as rates rise, a barbell structure can be used to take advantage of yields found in both short and long-dated maturities. When the rising-rate cycle concludes, and yield curves steepen, a focus on specific maturities can be employed to target roll-down returns.
- Credit: Credit may offer additional income that could help offset portfolio price declines in a rising-rate environment. As fundamentals improve and credit spreads tighten, bond prices have the potential to appreciate.
- Sector/individual security selection: Through rigorous credit analysis, potential credit opportunities and pitfalls when rates are rising can be identified.
- Structure: Positioning into premium-coupon bonds may boost performance as they’re defensive in nature and have historically outperformed the broader index in rising-rate environments.
- Cash/liquidity: Maintaining liquidity provides the opportunity to potentially capitalize on expected opportunities in credit, yield-curve positioning, and relative-value trading—especially during times of volatility.
Supported by rigorous credit research, Allspring’s Municipal Fixed Income team seeks to build high-quality, diversified portfolios across maturity and quality spectrums to potentially benefit investors in both rising-rate and falling-rate environments.
Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.