Key Component in a Year When Capital Preservation Needs Could Dominate
Tom Dalpiaz, Managing Director (January 7, 2016)
It seems that for quite a few years in a row now the year has started with a prediction by investors and market observers that “interest rates will likely rise this year.” You could date those rising rate expectations as far back as February 2009. That month was the end of a frantic five-month period that included bank and auto bailouts and the passage of federal stimulus legislation. While expectations of rising interest rates have varied in intensity since that time, they have managed nonetheless to become a persistent feature in beginning-of-the-year prognostications. It seems that each January, the thought of many investors and market participants has been “surely this year will be the year that rates will go up.” With the Federal Reserve finally raising its Fed Funds Rate target last month, that rising rate scenario seems more likely to actually come true in 2016.
While the case for higher rates does in fact look stronger this year, I would argue that a number of factors will likely turn that rise into a modest and gradual one. Very low levels of economic growth in Europe and Japan as well as a more slowly growing Chinese economy will temper economic growth globally. The price of oil and other commodities has fallen and demand for these items would have to bounce back meaningfully to reach worrisome inflationary levels. Domestically, broad demographic changes and a slower rate of household formation suggest moderate demand and an economy not likely to get too frothy. Bottom line, I believe domestic GDP and inflation data are unlikely to be robust enough to warrant a quick succession of rate hikes by the Federal Reserve. For good measure, I will throw in two more considerations: the Fed’s own statements about monitoring market reaction carefully with each gradual upward rate move and enough international financial/political events to produce numerous flight-to-quality rallies in Treasuries.
Whatever extent rates might rise this year, it is interesting to note that intermediate municipal bonds have tended to handle rising rate environments comparatively well. There have been six periods in the past ten years where ten-year Treasury yields have risen at least 60 basis points before dropping. The size of the rate movement in these periods has ranged from up 60 to up 137 basis points. The duration of each rate-rise period ranged from one to twelve months. In each of these scenarios, ten-year municipal bond yields rose proportionately less than Treasuries (on average one-third less).
How have intermediate municipal bonds fared during the last seven years of fairly persistent rising rate expectations? A look at the total returns of the Barclays 7-Year Municipal Bond Index since 2009 will show a more than respectable performance: +7.89% in 2009, +4.53% in 2010, +10.15% in 2011, +4.20% in 2012, -0.97% in 2013, +6.10% in 2014, and +3.26% in 2015. Investors who sat on the sidelines because they felt sure of an imminent and damaging interest rate rise will read those returns with some regret. Perhaps there is something to be said for staying in the game and avoiding the roulette wheel of interest rate timing.
When I review the factors that could impact municipal bond supply and demand this year, I conclude that intermediate municipal bonds could be a more than reasonable investment in 2016. The kinds of things that weaken the demand for municipal bonds (and cause prices to drop) seem to me to have low probabilities of occurring this year: passage of major tax reform reducing or eliminating federal income tax brackets, a previously undetected negative credit event, a buyers’ strike caused by massive “sticker shock” from muni yields being too low, or a very large reallocation from munis to stocks due to a rollicking equity market. A large increase in municipal bond supply could negatively impact munis but I believe new-issue volume related to refundings should temper overall new-issue volume coming to market. Steady demand for municipal bonds should digest the supply that comes along in 2016.
In laying out my positive view of intermediate municipal bonds for 2016, I am not suggesting munis will necessarily top all other asset classes, or that there is tremendous upside waiting to captured, or even that this particular point in the year presents an unusual value opportunity. I am simply suggesting that intermediate maturity, investment grade municipal bonds in 2016 are likely to be a resilient, workable, and ultimately satisfying investment for many investors given this year’s problematic landscape of investment possibilities. In a challenging year where capital preservation may come to top investors’ wish lists, I think munis can deliver in their typical workman-like fashion.
As a seasoned market observer, I present my market judgments with humility and the knowledge that random events and unforeseen consequences can confound the most carefully reasoned scenarios. The more time I spend in the investment world, the more I know markets make it a practice to confound the best laid logic and reason.
I know that a sloppy bond market, whether it is prompted by rational or irrational forces, can deteriorate quickly, particularly given liquidity concerns that exist in many of today’s bond markets. This is yet another reason why I believe in intermediate maturity, investment grade municipal bonds as an effective vehicle for achieving a number of investment goals through a full interest rate cycle. By driving in that kind of vehicle, I believe investors already place themselves in a relatively protective position while giving themselves the opportunity to garner attractive tax exempt yields.
Tom Dalpiaz manages an intermediate municipal bond strategy at Granite Springs Asset Management. The Intermediate Municipal Bond strategy was launched in September 2009.
Granite Springs Asset Management, LLC is a privately held SEC-registered investment advisor that specializes in fixed income portfolio management and tactical asset allocation investment strategies for private clients, family offices financial advisers, insurance companies, pension plans, and other institutional investors. The investment philosophy at Granite Springs is based on two principal beliefs; that asset allocation is the most important investment decision and; that disciplined risk management leads to superior returns over time.
Granite Springs Asset Management LLC is a Registered Investment Adviser with the U.S. Securities and Exchange Commission and qualified to do business in various state jurisdictions where required. Nothing in this article shall constitute investment advice. This article is for informational purposes only and the opinions expressed are the author’s own.
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