Amid a continued strong economic backdrop and persistently high inflation, the Federal Reserve appears set to deliver a series of interest-rate hikes in 2022. That makes some municipal bond investors nervous. But recent history suggests Fed rate hikes may not be such bad news for muni portfolios.
Increases in the benchmark federal funds rate tend to push bond yields up, with the biggest increases typically in shorter-maturity securities. That can result in falling prices and lower returns. But a look back at the last four Fed tightening cycles reveals that muni yields were not as sensitive to higher rates as investors might have thought and generally produced positive returns.
As Exhibit 1 shows, yields on shorter-maturity bonds rose more than those on longer-maturity ones, causing the yield curve to flatten. But in most cases, the overall increase was considerably less than the total increase in the federal funds rate over the course of the tightening cycle. In the last two cycles—from 2004-2006 and 2015-2018—the yield increase on intermediate- and long-maturity munis was considerably more modest than the rise in the fed funds rate.
