Municipal bonds and rising interest rates: A historical perspective
November 16, 2015
The October 2015 meeting of the Federal Open Market Committee (FOMC) meeting came and went without the central bankers taking any action. Federal Reserve watchers immediately pointed to wording changes within the committee’s ensuing communication, which hinted at a higher potential for a rate liftoff in December. On the morning after the communication was released, federal funds futures indicated a 50% probability of a December hike. (Heading into the meeting, they had only indicated a 30%-plus probability of a rate rise.)
And so the wait continues, as the Fed approaches a rate move. In early November, Fed Chairwoman Janet Yellen testified before the House Financial Services Committee and explicitly noted that the Dec. 15-16 FOMC meeting would be “live” and that, based on economic data leading up to the meeting, the central bank could begin the normalization process with a hike in the federal funds rate. After the conclusion of Yellen’s testimony, federal funds futures indicated a 58% probability of a hike. As the anticipated change in rates gets more near, it’s certainly worthwhile to take a moment to consider previous cycles of rate increases, and how markets reacted.
History as a guide
Once the Fed does begin to “normalize” rates, we expect the trajectory to be gradual and the interest rate curve to flatten. We anticipate a so-called “bear flattener,” a move in which rates in the shorter end of the curve go up by a greater degree than they do in the longer end. This flattening of the curve happens to be the consensus view among analysts, and was precisely the action that rates markets experienced during the 2004–2006 rate hike period. It’s this period that many strategists point to as the best approximation of what the next rate-hike period might look like.
From June 2004 to July 2006, the federal funds rate rose 425 basis points, from 1.00% to 5.25%. Yield curve action, as measured by the difference between the 30-year yield and the 2-year yield, flattened substantially for both municipal bonds and Treasurys: The Treasury yield curve began the period at a difference of 262 basis points and ended the period at 6 basis points, while the municipal yield curve began the period at a difference of 292 basis points and ended the period at 92 points. Isolating municipals, the 2-year segment of the curve rose by 164 basis points in the period and the 30-year segment actually fell by 36. This means that bonds on the longer end of the municipal curve significantly outperformed the shorter end of the curve.
Credit spreads respond
One other important factor to consider is embodied in this question: What happened to credit spreads during the 2004–2006 rate hike period? As a proxy for spreads during the period, we can look at the Municipal Market Data Baa general obligation scale minus the AAA general obligation scale. The results demonstrate that credit spreads tightened (or decreased) anywhere from 7 basis points to 29 basis points, depending on which part of the curve is examined. In general, 1-year to 19-year maturities performed the strongest (credit spreads tightened the most), with 20-year maturities and beyond tightening the least. This meant that bonds that traded with a spread off of the AAA scale (lower-investment-grade and below-investment-grade bonds) outperformed their higher-quality peers as spreads tightened through the cycle.
What transpired in that period makes sense to us, considering the forces at play: The Fed was raising rates because the economy was improving (in keeping with one of the Fed’s standing goals of preventing inflation from overheating). With the economy growing stronger, tax and project-related revenues were expected to be higher. Municipal credit was therefore expected to be improving, and so credit spreads rightfully tightened.
Putting credit research to work
The Delaware Investments municipal debt team favors an income/credit-focused strategy that deploys a fundamental credit process to assess each individual potential investment on its own merit. We focus on generating consistent long-term returns for our shareholders by emphasizing the credit segment of the market to provide alpha to our clients. We believe income is the most significant and predictable component of total return over time. Our credit selection discipline allows us to optimize the income component in the portfolios we manage. Relative to our peers, the typical portfolio we oversee will generally have an overweight exposure to the lower-investment-grade or below-investment-grade categories. We generally like to invest our overweights in credit — these comprise our alpha-generating ideas — and specifically on the strongest-yielding part of the municipal curve: the longer end.
While past experience does not necessarily predict the future, the next rate-hike period is expected to have a similar effect on rate curves as the 2004–2006 period, and we are aligned with the consensus view that expects a bear flattener with short rates underperforming long rates. We believe that credit spreads, despite being on the tighter end of historical ranges, should perform well or at least remain relatively stable, as long as “risk-off” sentiment does not permeate the psychology of the markets. Such sentiment would be most likely to appear if the U.S. economy were to slip back into a recession, an event that we would characterize as unlikely at this juncture.
In general, the Delaware Investments family of municipal bond funds performed positively during the 2004–2006 rate-hike cycle, and we found that we benefited from credit investments given how our intermediate strategies were positioned in that period. Our typical competitor’s intermediate strategy tends to hold higher-quality issues and does not have the credit exposure that we utilize in our strategy. We also generally favor utilizing the long end of the curve (15 years and beyond), which is considered “out of benchmark” relative to the typical intermediate strategy. These overweights to credit and curve, and their contributions to outperformance, were differentiators before and can be again. Standardized performance tables for Delaware Investments municipal bond funds are available here. Choose a specific fund from the list on the left side of the web page, and then select the performance tab. Standardized performance tables for Delaware Investments municipal bond funds are available here. Choose a specific fund from the list on the left side of the web page, and then select the performance tab.
For more information about the historical performance of Delaware Investments municipal bond funds, including performance in the 2004–2006 rising interest rate environments, please contact your regional director or call 877 693-3546. Standardized performance tables for Delaware Investments municipal bond funds are available here. Choose a specific fund from the list on the left side of the web page, and then select the performance tab.
Flows into the intermediate funds category were solid during the 2004–2006 period and have also been strong in 2015 as we approach the next rate-hike period. Year-to-date, intermediate strategies have seen positive net flows of 5% compared to 1% for all municipal bond funds (source: Simfund). This is not surprising, since many investors tend to shy away from longer strategies in the face of rising rates, preferring to stay shorter on the curve until rates actually rise. The fact that nominal rates are near historic lows only exacerbates that tendency.
We expect intermediate funds to see strong flows as the next rate-rising cycle gets under way, and we believe it makes sense for advisors to discuss this strategy as a viable option for those investors looking for credit exposure with less duration.
As suggested earlier, markets are looking toward normalization of the federal funds rate in the near future. While we do not look for the past to predict what lies ahead, this next rising-rate period is expected to have similar effects on the rate curves as did the 2004–2006 period. In a bear flattening environment, the long end of the curve outperforms (rises less than) the shorter end, and having an income cushion to offset the negative price action becomes paramount to maximizing your return potential.
Based on our view of the economy, which we believe will continue to progress (albeit at a moderate pace), we do not expect a “risk-off’ sentiment to pervade investor psychology, and this absence should allow credit spreads to at least be stable. While we anticipate that the market will experience occasional periods of volatility as the Fed raises rates, we will look to enhance portfolios opportunistically when appropriate. In this environment, similar to the 2004–2006 rate-hike period, we believe income-focused portfolios should have the potential to outperform relative to more interest-rate-sensitive strategies.
While the municipal market continues to see flows into municipal high yield funds (which has been the fastest growing segment of the market during the past few years), intermediate municipal bond funds have experienced solid flows as some investors have preferred to stay shorter on the curve as rates rise. We expect both trends to continue.
The views expressed represent the Manager's assessment of the market environment as of November 2015 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Bonds are rated by nationally recognized statistical rating agencies that include Standard & Poor’s, Moody’s Investors Service, and Fitch, Inc. Bonds rated AAA represent highest quality; however, the security’s credit rating does not eliminate risk.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
Bond funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
Funds that invest primarily in one state may be more susceptible to the economic, regulatory, and other factors of that state than funds that invest more broadly.
Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to state or local taxes and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.
Alpha measures the portion of an investment’s total return that is independent of general market movements. In the case of mutual funds, alpha typically describes the portion of returns that is attributable to the investment’s inherent value, apart from the portion of returns that can be attributed to broader market fluctuations.
The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.