"Gradual" Could Be the Key word for Bond Investors Right Now
Tom Dalpiaz, Managing Director (April 8, 2016)
While playing sports, athletes often block out extraneous thoughts by repeating key words to themselves in order to better perform a specific task at hand. For example, golfers will quietly verbalize a simple key word or short phrase to help them focus when preparing for a shot. Examples of key words for golfers might include “low and slow”, “turn”, and “through”. These simple, focused mantras tend to be more helpful than the usual thoughts that can enter a golfer’s mind such as “I hope I don’t hit this into the water”.
For investors, there could be an equivalent to the unhelpful “I hope I don’t hit this into the water” thought that often plagues golfers: a misplaced hyper-focus on blaring headlines and the daily financial market volatility that follows. Maybe investors can use key words to improve their focus and guide themselves through often confusing markets.
Right now, the most effective key word for bond investors could be “gradual”. Global economic activity is likely to grow gradually given lower growth rates in China and ongoing modest economic activity in Japan and Europe. Domestically, broad demographic changes and a slower rate of household formation continue to suggest gradual growth in GDP. Is there a domestic economic sector that seems poised to breakout and create something other than gradual GDP growth? It seems unlikely. While wage pressures have intensified a bit lately, commodity price declines and generally muted demand have kept overall inflation rising at a still modest, gradual pace. The latest comments from Fed Chairwoman Yellen also seem to suggest a small menu of gradual (and fewer) rate hikes this year with large side helpings of caution. With so many of these broad factors exhibiting gradual tendencies, it seems reasonable to suggest that any interest rate hikes that the market might experience this year will also be gradual.
Of course, random events and unforeseen developments can cause markets to spasm periodically and eliminate any semblance of gradualism at work. It is at those particular times that it may be most helpful for investors to employ the key word “gradual” as a reminder of larger forces at work.
The fundamentals of the muni market have contributed to more than reasonable total returns so far this year. The Barclay’s 7-Year Muni Index has a year-to-date total return of 1.84% while the Barclay’s 10-Year Muni Index has returned 2.33%. The long Barclay’s Muni Index is up 2.73%. The demand for municipal bonds remains quite strong as evidenced by sustained, week-after-week net positive inflows into muni bond funds (going back to October of last year). The supply of new issue municipal bonds has been fairly modest so far this year with total first quarter volume 12% lower than last year. While new muni bond issuance for new money projects is up, issuance for refunding purposes is down sharply.
While nominal tax-exempt muni bond yields available today often seem frustratingly low, I find it is helpful for muni investors to periodically remind themselves of the taxable equivalent yields munis produce for top federal tax bracket investors. Currently for these investors, tax-exempt municipal bond yields of 2.0% to 3.0% in the investment grade/intermediate maturity space translate into taxable equivalent yields of 3.53% to 5.30%. Treasury bonds with similar maturities currently offer yields of 1.1% to 1.9%. The market is seeing attractive value for munis in the broad four to eleven year range and more specifically in eight and nine year maturities.
In past commentaries, I have talked about the usual suspects in the muni bond market when it comes to troubled credits causing headlines (Illinois, Chicago, New Jersey, and Puerto Rico). The credit challenges of these issuers will persist for some time as will the political wrangling that inevitably is a part of resolving these complex problems. Given that these troubled credits are well known to muni market participants, they have not negatively impacted the broader muni market in a material way. Still, I continue to suggest remaining vigilant about credit quality and knowing what you own in the muni bond market.
My generally positive view of the municipal bond market this year remains the same as what I expressed in my January commentary. If anything, my sense may be even stronger that “gradual” will be the key operable word this year for bond investors. When it comes to interest rates, I remain a consistent non-believer in the timing game for conservative investors. I continue to believe that, particularly in this year’s likely bond environment, getting involved in the investing game is a more effective way of making progress toward achieving investor objectives. Wherever the market might be in the interest rate cycle, I believe benefits can accrue to investors when they are thoughtfully engaged in the muni bond market, applying expertise and diligence in the daily search to uncover value.
Tom Dalpiaz manages an intermediate municipal bond strategy at Granite Springs Asset Management. The Intermediate Municipal Bond strategy was launched in September 2009.
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