July 11, 2013
With the Federal Reserve hinting that positive economic developments in the U.S. could allow the Fed to begin paring back its $85 billion-per-month bond-buying program later this year, the general trend in declining interest rates is likely to reverse. For the overall economy, the good economic news is welcome. But for the bond market, an improving economy means the prospect of rising interest rates. This was not good news for the bond market and the reaction was swift and negative: In just a few weeks, yields of bellwether U.S. Treasury bonds rose to levels not seen since 2011.
As with most fixed-income asset classes, the municipal bond market faced a similar reversal in rates, which correspondingly pushed prices lower. The Barclays Municipal Bond Index dropped 2.81% in June, the fifth-worst monthly decline in two decades, as nearly $16 billion left municipal bond funds. In the single week ended June 26, investors pulled a record $7.5 billion out of municipal-bond funds, according to the Investment Company Institute.
Despite the recent volatility, Barnet Sherman, Portfolio Manager of the TIAA-CREF Tax-Exempt Bond Fund, says that municipal bonds remain a vital part of an investor’s fixed-income asset allocation. In this Q&A, he discusses the current investing environment and why investors need to look beyond the near-term uncertainty around Fed policy to build a healthy portfolio for the long run.
In a nutshell, what’s causing the rising yields and volatility in the municipal bond market?
The precipitating event was the announcement by Federal Reserve Chairman Ben Bernanke that the Federal Reserve was considering tapering the bond-buying program later this year. The Fed hasn’t actually stopped the buying, but the expectation is already pushing interest rates up. That, in turn, pushes down the price of existing bonds, since the lower interest rates on previously issued bonds are less attractive to investors as current interest rates rise.
Adjusting to the new interest rates in the Treasury market, interest rates in the municipal bond market rose as well. Nervous investors began selling off muni bond mutual fund shares. This has compelled portfolio managers to sell bonds to meet those redemptions, putting further pressure on muni bond prices.
What is your overall outlook for the municipal bond market?
This current period of volatility aside, we continue to have a positive long-term outlook on the municipal bond market. Over the last 32 years, the Barclays Municipal Bond Index has experienced negative returns in only five of those years. Moreover, on a three-year rolling average of those returns, assuming reinvestment, returns have been consistently positive—even during periods of steep market declines, such as 1994, 1999 and 2008 (see below).
Barclays Municipal Bond Index
Note: It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs.
TIAA-CREF’s long-term investment perspective benefits us in this market. Investors that take a long-term view will reinvest their dividends in these periods, thus reaping the benefits of compounding returns while avoiding the effects of daily price fluctuations.
What role should municipal bonds play in an individual investor’s portfolio?
Each investor must take into consideration his or her own circumstances and tolerance for risk, but we believe that municipal bonds should be a core holding in the fixed-income portfolios of many investors. It’s important for investors to look past today’s intense volatility and put recent events in perspective. What’s happening now is an inevitable, and we believe fairly brief, market adjustment to the Fed’s shift in policy. Investors need to focus on their own long-term goals and income needs.
Have muni bonds reacted differently than other types of bonds to recent events?
Recent events have created significant volatility and downward pressure on prices for all bond holders in this current period. Municipal bonds were not immune, reacting in line with other fixed-income asset classes.
But aren’t the Fed's statements about the improving economy good news for bonds?
An improving economy is a double-edged sword for the muni market. As the economy improves, increasing property values and tax revenue strengthen many issuers and make them more solid credits. Correspondingly, this will improve bond valuations. However, given the inverse relationship between bond prices and yield, rising interest rates will push bond prices lower.
Does the recent spike in interest rates increase the risk of municipal bond defaults?
Interest-rate fluctuations, even when they are as severe as those recently experienced, have little effect on the long-term creditworthiness of borrowers.
What impact do rising interest rates have on existing debt?
Since most municipal bonds are fixed-rate instruments, increases in interest rates do not directly affect the amount of issuers’ payments on existing debt. The increase in rates will likely affect the cost of servicing debt for municipalities that issue new debt in the future; however, since many municipalities will have increased revenue in a stronger economy, issuers will potentially be able to service future debt at higher rates with little risk of budgetary stress.
Will recent events affect the issuance of new municipal bonds?
In the short term, yes. New issuance has recently declined as municipal bond issuers postponed bond offerings both to finance new projects and to re-fund higher-coupon debt. Once the market settles down, issuance of bonds for new projects will probably resume fairly quickly. However, re-fundings are very sensitive to interest-rate changes. As rates rise, many planned re-fundings may no longer be economical, lowering the total amount of new issuance.
Is this lack of new issuance a concern for investors?
Just the opposite, actually. With the high volume of existing bonds being sold by mutual funds to meet redemptions, the last thing the market needs is more new bonds coming into the market from borrowers! That would drive prices even lower.
Do you have any guidance for investors on weathering this storm?
Look to the long term. Understand why the market goes up and down, and do your best to ignore it. It’s a simple lesson, but sticking to it is hard. That’s what separates successful disciplined investors from the rest.
The views expressed in this article are those of Barnet Sherman. These views may change in response to changing economic and market conditions. Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Strategies discussed do not guarantee a profit or ensure against loss. When considering municipal bonds, please consult with a tax advisor or financial advisor regarding tax implications.
TIAA-CREF is a national financial services organization and the leading provider of retirement services in the academic, research, medical and cultural fields. Further information can be found at www.tiaa-cref.org. Securities are distributed through TIAA-CREF Individual & Institutional Services, LLC, and Teachers Personal Investor Services, Inc., registered broker/dealers, members FINRA, distribute securities including the TIAA-CREF Tax-Exempt Bond Fund (Ticker: TIXRX). The Fund’s investment advisor is Teachers Advisors Inc.
Funds that invest in fixed-income securities are not guaranteed and are subject to interest rate, inflation, and credit risks. Consider the investment objectives, risks, charges and expenses carefully before investing. Please call 877 518-9161 or go to TIAA-CREF.org for a prospectus that contains this and other information. Read the prospectus carefully before investing.
Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value.