May 12, 2022 | Cameron Parkhurst
We often receive questions from RIAs and their clients trying to decide whether they should invest in individual bonds during periods of rising rates. As we cover all fixed income asset classes, but deal predominantly in municipals, both taxable and tax free, we believe that this is an important topic to bring to the table currently.
Recently, bond market participants’ focus has shifted to the impact of inflation, rising interest rates, and whether to stay invested or to sit in cash. As rates have climbed throughout 2022, investor questions have extended beyond the immediate impact on municipal bonds to the broader macroeconomic concern of whether the U.S. economy is overheating, and if the U.S. Federal Reserve (Fed) is behind the curve with its policy response.
While rising Treasury yields have led to negative returns for municipal bond indexes in the first part of 2022, we should take a moment to re-evaluate a buy and hold investment strategy and examine the positive long-term historical performance of municipal bonds during other periods of rising rates. Thus, we highlight several reasons why history suggests investors would be well served by sticking with municipals allocations here.
Buy/Hold Strategy and Historically Positive Returns
One of our key strategies is to buy attractively priced, high quality, odd lot individual bonds and hold them as they roll down the curve towards maturity. This involves consistently reinvesting back into the portfolio as rungs of a bond ladder mature, coupon income pays in, or new cash becomes available.
The buy and hold aspects to a portfolio essentially eliminate any need for market timing and give the investor a much better sleep at night factor, as they know when they can expect to see their principal returned (at par value). If rates are up when it is time for reinvestment, a higher economic yield expectation can be realized in the portfolio. However, if rates are lower, reinvestment will be at lower rates while the held portfolio has appreciated in value on paper.
Importantly, with the inflation numbers temporarily on the rise, leading to increasing yields all through this calendar year, those investors who are sitting in cash are paying a higher cost to make this “bet”. By taking essentially zero duration, hugging the very front end of the curve, and assuming that rates will be perpetually increasing, they could be missing out on invaluable opportunities to build higher economic yield and income structure into their portfolios.
It is always difficult to predict the path of rates, and making investment decisions at inflection points can be even more difficult. Many think we could be in a situation where a long-term cycle of falling rates could be bottoming, and that the Fed could be on a path of longer or larger structural moves regarding Fed funds policy, which is the anchor of our yield curve. With this, we believe that you will find it helpful to take a historical look and evaluate how munis have done during years where Fed rate hikes have happened:
Over the last seven times that the Fed has raised rates, net of coupon income and subsequent reinvestment, munis have rewarded investors with overall positive total returns. This highlights the important component of consistent portfolio reinvestment. If one is being proactive about systematic reinvestment, historical returns speak for themselves.
Importantly, during times when we have seen short periods of negative returns (above), in 95% of cases, those that stayed invested and added systematically to portfolios fared well with positive returns looking out 12-24 months. In fact, there have been zero 24-month rolling time periods where munis have had negative returns in the last 20 years.
Correlation
As we saw in the 2008-2009 period, and then recently here in 2022, during times of more extreme market turbulence, correlation between all asset classes can increase. Over short periods of time, nearly every investment class can be moving in the same direction. However, munis have historically displayed very low correlations with other asset classes, which can be a value additive diversifier for overall portfolios:
How to React to Interest Rate Moves?
Thus, the common question that we get from Advisors is “What to do now?”. Our approach has always been to have focus with a longer-term perspective, have conviction in the belief that cash is not king, and that the power of buying cheaper bonds (often with higher coupons) will be a driver in potentially attractive future returns.
While we can never promise anything in this industry, markets like we have seen in the first four months of this year can provide great opportunity for the long-term bond investor. It is a sloppy market, and we are better able to win attractive paper while utilizing the bid side of the market (a key to our value-add proposition).Additionally, when plugging in an expected yield number that is closer, or above, to the 4% fixed income standard for new bond purchases, overall financial plans are much more easily reached. It is really a market that we all have been waiting to see for some time now.
Thus, our recommendation is to stay the course, continue to buy short to intermediate term bonds that are appropriate for an investor’s tax situation, and to maintain a high credit quality where possible. History shows that this has been a good strategy looking backwards, and we are confident in it looking forward when evaluating the current yield curve and opportunities in municipal bond markets.
If you have questions needing follow-up dialogue, have portfolios needing review/analysis, etc., please do not hesitate to reach out to any member of our fixed income group.
Thanks,
Your PeachCap Fixed Income Team
The above summary of statistics/prices/quotes has been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. The information and opinions herein are for general information and illustrative use only. This data is not meant to replace Adviser's portfolio management/performance reporting systems. Please consult Adviser performance reports for actual performance data. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice. Past performance is no guarantee of future results. Market risk is a consideration if sold prior to maturity. May lose value. Not insured by any federal agency. Subject to availability and price change. Securities offered through PeachCap Securities, Inc., member FINRA, SIPC, MSRB registered.