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Municipal Podcast recorded on December 6, 2016

Making Sense of Recent Muni Volatility

Podcast Transcript

Welcome to the Breckinridge podcast. This is Ariana Jackson and joining me today I have vice president of our Consultant Relations Group and CFA, Jeremy Jenkins. Jeremy, thanks for being here today.

Thanks, Ariana, happy to be here.

So given the recent increase in interest rates and subsequent bond market volatility, we thought it would be a good time to spend today discussing the recent move, what it means for bond investors and its impact longer term. To begin, Jeremy, how much have interest rates moved?

Well, in short, a lot. Interest rates for Treasury and municipal bonds started to rise towards the end of the third quarter after touching all-time lows in July. Yields then continued to grind higher at the beginning of this quarter, but at a measured pace. For example, a 10-year AAA municipal bond started October at about 1.5% and by the day of the presidential election was about 20 basis points higher. Now since the election to today is where we have seen the most volatility within fixed income broadly, probably the most since the Feds taper tantrum back in 2013. So that 10-year spot of the municipal bond curve is up over 80 basis points from the election to today, which is a substantial move for about a month's time.

Certainly, so what is driving this move?

So with the election of Donald Trump, major changes in fiscal policy are expected and that has significantly altered the outlook for the bond market. At the forefront of the President-elect's platform are personal and corporate tax cuts as well as up to $1 trillion in new infrastructure spending. This potential shift in fiscal policy has induced recently a risk on trade that has benefited most risk assets, including the U.S. equity market. However, in the Treasury market, this has resulted in sharply higher interest rates, especially further out the yield curve due to the inflationary pressures that would likely result of such a set of policies And adding to the upward pressure recently on rates has been a couple things, including reduced monetary policy support for long end bonds, as well as China sales of U.S. Treasuries. Now, meaningful changes are also likely in monetary policy. We expect a rate hike next week by the Fed and looking out to next year, the Fed is anticipating an additional two hikes.

Okay, now have municipal rates followed treasuries?

So initially following the election, munis were slower to react than Treasuries which is typically the case. So muni rates rose but not as much as on the Treasury side initially, but soon thereafter, that dynamic shifted as municipal mutual funds started to report outflows and there were some pricing in of federal policy shifts that could impact munis specifically, such as changes to tax policy, infrastructure spending, the ACA repeal, etc. As a result, municipal Treasury ratios are over 100% across the yield curve.  Some of those specific risks to munis such as tax risk are a real risk, but with the 10-year ratio currently around 106%, for instance, you are being paid for it more now than at times in the past.

So with interest rates rising so much in a short period of time, what has been the impact on bond prices and performance?

As one might expect, given that bond prices move inversely to interest rates, bond performance has been quite negative. For example, the broad municipal bond index was down 3.73% in November which is actually the worst month of performance since October 2008 following the collapse of Lehman Brothers.

So most investors understand that rising interest rates results in the lower bond prices, which has been the case recently, but is rising rates all bad news for fixed-income investors?

Definitely not. There are a few things to keep in mind as a fixed income investor when you see yields up, prices down. First of all, those who invest in bonds directly versus through say an ETF or bond fund should be better positioned to weather bond market volatility. The reason is, owning an individual bond is much different than most other investable securities, where your return is reliant on the market price. Instead owning a bond or portfolio of bonds, you have an internal rate of return which can be measured through the yield to maturity that can be predictably calculated. And the reason this is predictable is that the return comes from cash flows that are earned independent of market prices, and this includes a return of principal. In this way, a bond portfolio can offer a haven from market dislocation and thus an effective counterbalance to risk assets that rely on price return.

Okay that makes sense. Is there anything else?

Yes. The good news of higher interest rates is of course better income opportunities. Bond investors can, in time, benefit from an increase in yields because they can reinvest at higher rates as coupon cash flow accumulates, bond holdings mature, or bonds are sold. The fact is that interest income and not price appreciation is the primary driver of a fixed income portfolio’s total long-term return. With a diversified portfolio of individual bonds, an investor can reinvest maturities at higher market yields, building their portfolio’s return over time. Further, this higher-level of income can potentially help offset rate-induced price fluctuations in the long run. Lastly, a benefit to bondholders after a rate rise such as this can be to do some tax loss swapping. This involves selling a depreciated bond, realizing the capital loss and reinvesting in a similar but not identical bond. Now while a separate account investor can avoid realizing a loss by holding a bond to maturity, there are potentially significant advantages to taking a loss in a rising rate environment. Realizing those losses can allow investors to offset capital gains that they have elsewhere and to also potentially carry that forward in further years and it also allows the fixed income portfolio to maintain and potentially improve portfolio value, structure, and income.

So, Jeremy, how does Breckinridge effect tax loss harvesting?

Yeah, while we have been looking to effect tax loss swaps in accounts, we would note that a variety of factors do need to line up for the realization of losses to make sense. As such, we do want to underscore that not every portfolio will have tax loss swaps performed prior to your end. And of course investors should talk with their tax and financial professionals before taking any actions.

Definitely. So for investors looking to make or add to a bond allocation, is now a good time to invest?

Yeah, that is always a tricky question to answer as I think there are always a lot of important considerations when deciding to invest in the bond market or really any market for that matter.  But that said the bonds on offer today are at higher yields than we have seen in a while, going back to that AAA ten-year municipal bond, which is often used as a market barometer that is the highest it has been since January 2014, almost 3 years ago. In addition credit spreads are a bit wider for the year and the yield curve is a bit steeper than at the start of the year.  Also in terms of relative value, as I mentioned before, the municipal Treasury ratio is about 100% or more across the yield curve.

So it sounds like there is a good case to be made for value in municipal bonds.

Yeah, I think if you look at the relative value versus other bonds, it is there. And in terms of absolute value munis are offering more yield than they have in the past few years, but of course in the near-term, yields could go higher from here or yields could go lower. You can make good cases for both scenarios. Longer-term, we anticipate higher rates but also for that move to be more gradual than the recent volatile movements, and we would remind investors trying to top tick in that entry point in yields is a very difficult thing to do. It is rarely done perfectly.  Rather than get too caught up in that aspect of allocating, we think it is important to remember that the role high-grade municipal play in a portfolio is still the same. They are still a source of reliable tax-exempt income, capital preservation, and ultimately a counterbalance to risk assets such as equities. And the good news today is that that income available on municipal bonds has improved dramatically from just a few months ago.

Great. Thank you, Jeremy. We hope that you in the field found this informative and we look forward to you joining us again next time


DISCLAIMER:The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message. Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state and local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.