Confusing Interest Rates? Focus on Uncovering Value Through the Cycle
with Tom Dalpiaz, Managing Director (January 28, 2015)
“Those who cannot remember the past are condemned to repeat it.”
“History doesn’t repeat itself, but it does rhyme.” Mark Twain
Let’s flashback thirteen months to December 2013 and recall the overwhelming consensus that interest rates were very likely to rise in 2014. Unfortunately for the prognosticators, ten year Treasury yields on January 2, 2014 posted their highest level for the year and proceeded to fall for the rest of 2014. Now let’s flashback just one month or so and recall the predictions of many observers that surely 2015 would be the year interest rates would rise. So far in 2015, January 2 has marked the high point for ten year Treasury yields. Is History repeating here or just rhyming? It is too soon to tell of course. Only one month has gone by and we still have plenty of 2015 remaining. I’m not suggesting that the movement of interest rates this year will repeat last year’s pattern. I am also not casting any dispersions on those who suggested rates could rise in 2014 and will rise in 2015. At the time, those predictions were reasonable and backed with logical arguments. Seasoned investors are well aware that interest rate predicting is a notoriously difficult game to play so there should be no joy or surprise when thoughtful market observers miss the mark. I count myself among those who thought, at the beginning of last year, that the bias for rates in 2014 could be somewhat higher as the year progressed. But I have also long been in the camp that any rate rise, if it were to occur, would generally be gradual. I have believed for some time that countervailing forces at work in the economy and markets would be strong enough to dull the impact of rising rates, particularly in the intermediate municipal bond space. I hold the same view for 2015. Those countervailing forces have proved to be quite strong and dominating to the point of actually pushing rates downward in a meaningful way this year.
What do I take away from the bond market’s movements so far in 2015? Investment markets are complex organisms and will confound you at every turn. The overall macro story guiding markets week to week can change in fairly short order. Markets will reflect their seemingly schizophrenic participants as they struggle to solve the impossible riddle of what’s temporary and what’s the beginning of a game-changing trend with staying power. Given the steady stream of international political events and calculations in today’s world, flight to quality Treasury bond rallies are a regular feature bond market dynamics, though unpredictable in their timing.
As markets digest sharp interest rate movements, investors can speed up or slow down the pace at which cash is deployed. I believe this is a reasonable tactic to employ for short time periods but I would caution against getting too cute about it and making it an all or none proposition. Given the generally muted volatility of munis compared to Treasuries and the muni bond market’s relatively inefficient nature, I believe it is more effective for muni bond investors to focus on finding value in misunderstood, mispriced, and overlooked bonds every day. Making short-term judgments on the direction of rates is fine. But particularly for the muni bond investor, I suggest that staying in the game through the full cycle and regularly uncovering value with a steady deliberate approach is time better spent. I believe that kind of effort is more likely to achieve bond objectives than a hyper-focus on the future direction of rates.
Munis By The Numbers
(Sources: Bloomberg, Barclays Capital)
When does 2.31% = 4.08%? When you are an individual investor subject to the top Federal income tax brackets and you capture a 2.31% yield from tax-exempt municipal bonds.
The 2.31% 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 6 to 7 years, portfolio duration range 3.7 to 4.7 years.
10-year High Grade Muni bond yields as a percentage of 10-year Treasury bond yields: 107% (compared to an average ratio of 98% for the past ten years).
Moving from cash to 5-year munis: +125 basis points (Yield difference on tax-exempt money market funds and Single A rated tax-exempt muni bonds with a 5 year maturity).
Moving from 2-year munis to 10-year munis: +167 basis points (Yield difference on Single A rated 5 year tax-exempt muni bonds and Single A rated 10 year tax-exempt muni bonds).
+0.64% January total return of the Barclays 3-Year Municipal Bond Index (+1.51% for all of 2014)
+1.54% January total return of the Barclays 5-Year Municipal Bond Index (+3.19% for all of 2014)
+1.94% January total return of the Barclays 7-Year Municipal Bond Index (+6.09% for all of 2014)
+2.01% January total return of the Barclays 10-Year Municipal Bond Index (+8.72% for all of 2014)
+2.53% January total return of the Barclays Long Municipal Bond Index (+15.39% for all of 2014)
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.