New York - It might feel like a different landscape for investors in municipal bonds after the big moves in yields and prices this past month. Thankfully, they are historically rare. But like the "taper tantrum" of 2013, they can be unnerving when they do happen.
Yields on the U.S. 10 year Treasury note were trading at 3.23% as of this writing, up almost 83 basis points in 2018 and well above their July 2016 low of 1.36%, according to Bloomberg data. Meanwhile, the yield on 10 year AAA munis has increased 68 basis points in 2018.
Not surprisingly, investors can get nervous when volatility ratchets up, and the Federal Reserve is raising rates. When asset prices are declining, a certain amount of investor anxiety is natural. The impulse to cut and run can be overwhelming.
However, we believe a professionally managed ladder strategy can help investors stomach volatility and focus on the long term. Our Laddered Investing Interest Rate Scenario Tool nicely illustrates how this can work for advisors and investors. The lowest yielding bond will roll out of the ladder and be replaced by the longest and highest yielding maturity in the portfolio. When rates rise, reinvestment occurs at those new higher rates/lower prices.
Rapid rate increases such as we have seen recently can have very little impact on laddered strategies in the long run, because of the benefits of reinvesting at higher rates. For example, looking at the cumulative return today of an A-rated muni 5-15 year ladder over a 10-year time frame, the annualized total return is 3.50%. If you run a scenario where you raise rates 100 basis points over the next year, the annualized total return remains 3.51% (losses in year one are offset by higher yields going forward).
This is just one example. Running different scenarios over a 10-year time frame, it is difficult to derive a scenario where the cumulative total return is negative. For example, a 500 basis point rate increase over five years will produce six years of negative returns, but 10-year cumulative return is still 29.54%.
Investors may worry that a flattening yield curve will make a ladder strategy less effective. If it were to occur, it might however historically demand shifts down the muni curve when rates rise keeping the curve steep. That has been the case in 2018, where even though the Treasury curve has flattened, the municipal curve has steepened with 5 year AAA muni yields rising 43 basis points, but 15 year AAA muni yields rising 66 basis points.
Bottom line: Our Laddered Investing Interest Rate Scenario Tool can help show the benefits of an equally weighted ladder when rates rise. Financial advisors can use this tool to help investors reach their Eureka moment and help them preserve capital.
The output of the calculator is for educational purposes only and should not be considered investment, legal or tax advice. The output is general in nature and may not apply to your individual tax situation and is not intended to serve as the primary or sole basis for your investment or tax-planning decisions.
An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Rising interest rates could reduce the value of the bonds in the portfolio, thus adversely affecting the value of the overall investment.
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