What Bond Managers Can Do Before and After Rising Rates
with Tom Dalpiaz, Managing Director (September 4, 2014)
The next sizable interest rate rise deserves a prize of some sort. It may be the most persistently anticipated, talked about, and unfulfilled interest rate rise to occur over the longest period of time. It has been at least five and a half years (dating back to the passage of the stimulus in February 2009) since a steady chorus of market observers began suggesting that a sizable interest rate rise was in the near future. You might even date the start of this prediction a couple of months earlier to late Fall 2008. Since that time, the view that a rate rise was around the corner has persisted with varying degrees of intensity. In the fourth quarter of 2010 and again from May to September last year, it even looked as if that long-awaited rate rise had finally materialized. It didn’t. While it hasn’t been in a straight line, the general direction of interest rates has been down since February 2009. The month just past was yet another strong one for municipal bonds as yields trended downward.
We agree that a rise in interest rates from current levels is a reasonable view to hold. We understand where we are in the overall interest rate cycle and the forces at work presently or soon to intensify that will prompt a rise in rates. We also recognize the strength of other factors that have delayed and are likely to continue to delay the long-awaited interest rate rise so many have predicted and feared. We lean on the side that suggests a sizable rate rise will take some time to get here, perhaps another nine to twelve months. Regardless of the debate about exactly when rates will start going up in earnest, bond investors and portfolio managers must work with the markets that exist presently. Investment objectives are unlikely to be fulfilled by investors sitting on the sidelines waiting for the proverbial “all clear” bell to ring.
Professional bond managers can employ a number of strategies to prepare for and work within a rising rate environment whenever it comes along. Our commentaries have regularly extolled the virtues of investing in intermediate maturity municipals (3 to 15 years, mostly 3 to 10). By dwelling in intermediate maturities, investors already put themselves in a position to lessen the impact of rising rates. Bonds with above average coupons and call or sinking fund features tend to be defensive in their price action and are likely to decline less in price when rates rise compared to current coupon, discount, and zero coupon bonds. Adding more defensive-oriented bonds and reducing interest rate-sensitive bonds in a portfolio can also help dull the impact of rising rates. Performing bond swaps to shorten portfolio duration and/or improve credit quality can help to remove the parts of a portfolio more vulnerable to rising rates. Using discretion to slow down the pace at which cash is invested can help take advantage of a rising rate trend. A carefully designed portfolio maturity structure and appropriate bond swapping of shorter maturities can also present reinvestment opportunities that take advantage of higher yields as they come along.
Bond portfolio managers are not magicians, of course, and they can’t reverse the laws of bond mathematics. But it is their bread and butter to create and manage portfolios in a variety of bond environments, particularly in difficult periods of rising rates. An effective manager can employ techniques that help dull the impact of rising interest rates while honoring the diverse objectives investors have set for their bond assets.
Munis By The Numbers
(Sources: Bloomberg, Barclays Capital)
When does 2.37% = 4.18%? When you are an individual investor subject to the top Federal income tax brackets and you capture a 2.37% yield from tax-exempt municipal bonds.
The 2.37% yield stated above is our conservative estimate of an average yield to maturity for a muni bond portfolio constructed under present market conditions with the following parameters: all investment grade credits, average credit rating A1/A+, all bonds mature within 15 years, average maturity 5 to 6 years, portfolio duration range 3.5 to 4.5 years.
10-year High Grade Muni bond yields as a percentage of 10-year Treasury bond yields: 93% (compared to an average ratio of 98% for the past ten years).
10-year Single A rated Muni bond yields as a percentage of 10-year Treasury bond yields: 142% (compared to an average ratio of 125% for the past ten years).
Moving from cash to 5-year munis: +107 basis points (Yield difference on tax-exempt money market funds and AA rated tax-exempt muni bonds with a 5 year maturity).
Moving from 2-year munis to 10-year munis: +225 basis points (Yield difference on AA rated 2-year tax-exempt muni bonds and AA rated 10-year tax-exempt municipal bonds. Average spread for the past five years is 225 basis points).
+0.24% August total return of the Barclays 3-Year Municipal Bond Index (+1.36% YTD, +1.33% for all of 2013)
+0.71% August total return of the Barclays 5-Year Municipal Bond Index (+3.15% YTD, +0.81% for all of 2013)
+0.93% August total return of the Barclays 7-Year Municipal Bond Index (+5.37% YTD, -0.97% for all of 2013)
+1.28% August total return of the Barclays 10-Year Municipal Bond Index (+7.34% YTD, -2.17% for all of 2013)
+1.86% August total return of the Barclays Long Municipal Bond Index (+12.37% YTD, -6.00% for all of 2013)
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The opinions expressed are those of the Granite Springs Asset Management LLC Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. This material is for educational purposes only. Granite Springs Asset Management LLC is an investment adviser registered with the US Securities and Exchange. Registration does not imply a certain level of skill or training. More information about Granite Springs Asset Management LLC can be found in its Form ADV which is available upon request.