U.S. Treasury yields recently spiked to levels not seen since 2011. 10-year Treasuries have surged approximately 0.17% over the past week, and are now trading close to 3.22%. Yields on Treasuries maturing in 30-years have increased 0.20% and have caused the yield curve to steepen. Yields on short-term instruments have also moved, as evidenced by the current 2.60% rate on one-year Treasury bills. Looking back, this recent increase in yields actually began a slow but steady climb commencing in early September. Treasury yields in 10-years and 30- years have increased by approximately 0.37%.
Stronger economic data, higher inflation expectations, and the Fed’s interest rate hikes are cited as the major culprits. However, there are technical factors at work as well. Last month, a provision of last year’s tax reform bill, allowing corporations to deduct the cost of contributions made to employee pension plans at the old 35% income tax rate, expired on September 15. The new tax legislation’s tax cuts are also pressuring the federal budget, which has necessitated more Treasury debt issuance. China has trimmed its purchases of our debt as well, possibly attributable to the trade skirmish. The optimistic U.S. growth story is also increasing the hedging cost for investors in Treasuries from Japan and the eurozone. The spread between the U.S. Treasury 10-year Note and the German Bund is now 265 basis points.
The municipal market has weathered recent yield volatility much better while decreasing its relative value. Municipal yields have increased by just 23 basis points to 2.70%, compared to a 37 basis point move for the same maturity Treasury security.
While past bond market sell-offs have usually worked to the benefit of stocks, this relationship does not appear to be holding currently. Today’s higher interest rate levels are presenting two potential hurdles for stocks. First, arguably, borrowing costs are now at levels that are beginning to impact corporate balance sheets. The effect is already being felt in emerging markets that purchase goods mainly valued in U.S. dollars. Rising interest rates increase the value of the U.S. currency—making it more costly for foreign entities to borrow—and emerging market stocks have been among the worst market performers so far this year.
Second, many strategists believe that the bond and stock markets are rapidly approaching an inflection point—3%+ bond yields represent a better value than equities that are still close to record levels. High-grade bond yields are significantly higher and more attractive than the dividend yields on most high quality stocks. Asset allocation models may be shifting to a higher fixed income allocation.
Last month, the Fed raised the overnight Federal Funds rate by one-quarter percentage point from 2.00% to 2.25%. It is the third rate hike this year. A December rate bump is also possible, and the consensus call is for three additional quarter-point moves in 2019. SMC FIM maintains that municipal investors should not be swayed from either maintaining current municipal holdings or making new commitments to the municipal market at this juncture. The empirical evidence from past Fed tightening cycles suggests investors should stay the course.
During the fourth quarter of 2017, SMC FIM published a detailed analysis supporting our view. In view of the passage of another year and three more Fed moves, we are publishing an update on our still constructive municipal market outlook.
SMC FIM recognizes there is a common misconception in the marketplace that rising short-term interest rates bode similarly or worse for other maturity tenors along the yield curve. We provide historical evidence refuting this myth that a rise in short-term interest rates necessarily leads to negative performance for longer maturities. The graph below highlights the six periods during the past 32 years when the Fed has embarked on a tightening cycle by raising the Fed Funds overnight borrowing rate. The shortest cycle lasted nine months and the longest cycle lasted two years. The current cycle, commencing December 16, 2015, is closing in on three years and encompasses eight moves and over 200 basis points of rate tightening.
The severity of the 2008 recession caused the Federal Reserve to lower short-term interest rates to near 0%. The ensuing seven years of extreme monetary accommodation facilitated the economy’s recovery, resulting in a multi-year period of higher financial asset prices. Beginning in December 2015, the Fed reversed course and has been slowly raising the Fed Funds overnight borrowing rate.
|Tightening Cycle||Months||Fed Funds Increase||Tightening Cycle Performance*||Tightening Cycle +/- 6 Months Performance**|
|Dec 1986 – Sep 1987||9||1.37%||-3.10%||15.55%|
|May 1988 – Feb 1989||9||3.25%||6.65%||19.60%|
|Feb 1994 – Feb 1995||12||3.00%||-0.76%||11.28%|
|Jun 1999 – May 2000||11||1.75%||-0.86%||7.02%|
|Jun 2004 – Jun 2006||24||4.25%||9.59%||14.33%|
|Dec 2015 – ?||33+||2.25%||5.28%||?|
The chart above provides greater detail on past Fed tightening cycles. The fourth column, “Tightening Cycle Performance,” counters the misconception that rising short-term interest rates are inevitably a bad harbinger for longer-term municipal bond market performance. During two of the five historic tightening periods, the municipal bond market, as measured by the Bloomberg Barclays Municipal Bond Index, registered positive performance (periods #2 and #5). Performance during the current tightening cycle that commenced in December 2015 has also been positive (5.28%).
The average length of the five prior tightening cycles was just over one year, which in our opinion is too short of a timeframe to draw any meaningful conclusions. SMC FIM believes that investors need to be long-term focused. Concentrating on short-term results can be detrimental if impulsive portfolio moves result. History makes a strong case for staying the course by staying invested, which is especially relevant to the municipal market, given the lag effect of rate moves on the municipal bond markets.
SMC FIM prefers to view market returns through a longer-term lens. Our analysis measures municipal market performance over a slightly longer period than that defined by the Fed tightening cycle. The time horizon utilized in SMC FIM’s preferred analysis begins six months before the actual commencement of Fed tightening and is also extended by an additional six months after the conclusion of the cycle (last column in the table). A total of twelve months was added to the tightening cycle timeframe.
Observing performance over the additional twelve months in the preceding table provides a perspective worth noting. The municipal market registered significant positive returns during all five time periods. The average measurement period lasted just over two years. The worst market performance during any observed period was 7.02% (cycle #4), which lasted 23 months; the other four periods generated double-digit returns over time horizons ranging from 21 to 36 months.
As measured by their respective Bloomberg Barclays indices, municipal bond performance has been marginally negative through the first nine months of 2018 at -0.40%, and has outpaced U.S. Treasury bonds (-2.44%) and corporate bonds (-2.33%). There are a number of reasons why.
The correlation of municipal bond price movements to taxable counterparts is quite low. When Treasury yields move, municipal security yields generally move in the same direction but at a slower pace and to a lesser degree. Therefore, we believe that they are less interest rate- sensitive. The municipal market’s large and varied investor base also lends support. Taxable bond markets are primarily driven by large institutional investors and traders that assist in making them more efficient. On the other hand, the tax-exempt marketplace is dominated by retail investors, who are much less prone to react to changing financial and economic conditions. Price volatility is reduced due to the inherent inefficiency of this large and fragmented market.
The technical condition in the municipal market provides additional price support. Supply is shrinking. Tax-exempt debt issuance has been declining and has dropped by 15% through the first three quarters of 2018 alone. The reduction is mostly attributable to the change in federal tax law passed late last year prohibiting future advance refundings of outstanding municipal debt.
The 2018 tax reform act limits the state and local tax (“SALT”) deduction to $10,000. The impact on states such as New York, New Jersey, California and Connecticut will be quite severe. Investors residing in high-tax states should be looking more to in-state tax-exempt bonds in order to shelter more income from federal taxes.
History has shown that being under-allocated to the municipal asset class could lead to sub- optimal investment performance, particularly from a longer perspective. Compounding the problem could be a lack of investible supply in the future. Many economists are now forecasting an economic slowdown or possible recession in the next twelve to twenty-four months.
So, how should municipal investors position themselves in the current interest rate environment? SMC FIM’s view on yield curve positioning has not changed. Bonds positioned further out along the yield curve have proven to be less volatile and have also performed better than shorter maturity securities when the Fed is in a tightening cycle. Callable bond structures can be utilized to manage duration risk. SMC FIM recommends that investors maintain their fixed income investment allocations and emphasizes trying to maximize performance through the receipt of coupon payments.
The recent spike in bond yields should not be a deterrent to municipal bond investors. In our view, the financial markets are approaching a point of risk/reward revaluation: at what point do higher bond yields become more attractive than the potential for higher equity valuations? The recent stock sell-off in response to rising bond yields is possibly signaling a change in market sentiment.
The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management ("SMC FIM"), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.
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