Inflation & Higher Interest Rates & Municipal Bonds, Oh My!

While Treasury yields have further room to move higher, certain factors will likely combine to limit their advances. Risk-remote assets (on a relative basis) are far from falling out of favor and let’s not forget that the level of U.S. yields remains very compelling on the global stage. Nevertheless, their upward velocity can be expected to reflect the fear factor of inflation and the attendant response from our friends at the Fed. Although waning, muni fund flows have been positive for 33 consecutive weeks, yet we think that associated selling pressure will likely impact flow behavior through year-end. As we know, inflation and a sustained increase in interest rates can erode the value of fixed income investments given capital depreciation in a rising rate environment. In response to shifting economic and interest rate conditions and the overall expectations for inflation and the national recovery, municipal bond investors can take steps to mitigate the potential for portfolio devaluation as interest rates move higher. For now, munis are outperforming UST, both on a month-to-date and year-to-date basis, and we have reason to believe that the better relative returns can be sustained. One of our recurring themes centers on the rather unique technical attributes that have remained historically strong and that often provide the foundational support for municipal bond performance. In addition to the tax-efficient characteristics of the asset class, municipal bond investors are drawn to the high quality and diversification benefits that help ensure preservation of capital and a reliable income stream. At certain times throughout the year, muni reinvestment needs become more pronounced, such as what we are accustomed to seeing during the summer months, often a time of net negative supply.

Against this backdrop, municipal bonds have historically outperformed high-grade debt instruments during periods of rising interest rates. Now is the time to conduct active and strategic portfolio reviews with an eye focused on security selection and the most appropriate construction that can weather the headwinds of higher interest rates. Preserving credit quality is particularly important in a rising rate environment where spread differentials may become more pronounced with weaker credits potentially exhibiting greater diminution in value. Municipal bonds tend to offer above-market taxable equivalent yields given the tax advantage nature of the asset class compared to other types of bonds. Thus, the higher yields provided by municipal securities result in less sensitivity to shifts in interest rates than what would be experienced by corporate bonds. Today’s still currently low muni interest rate environment causes investors to think defensively, and premium municipal bonds may offer a viable investment solution. Premium bonds can provide a defensive buffer in a rising rate environment, and as the Fed launches its tightening cycle, this becomes more relevant. On a relative basis, Premium Bonds tend to not perform well in an appreciating market, but rather they cushion adverse price performance in declining markets (i.e. rising rates) because of their bigger coupons. Individual investors seeking relative value in today’s market – and who are not trading oriented – should seriously consider premium bonds.

A premium bond trades at a premium price in the market because its stated interest rate is greater than currently available market rates, with amortization of the premium calculated to par over the life of the bond. Essentially, the higher cash flow – and the flexibility to apply this cash flow to future market investments – underlies the basic logic for buying premium bonds. Therefore, additional tax-free income compensates for a higher purchase price. Simply put, premium prices on bonds buy high future income and actually represent a cheaper buy in most instances. Premium bonds can provide less secondary market price volatility than similar maturity bonds selling near par or at a discount. This is especially important to those investors concerned with the prospects of adverse price performance in declining markets. Generally, the higher the coupon rate, the smaller the price fluctuations for a change in interest rates.

For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Professional.