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Investment Ideas 2022: Explore three key themes dominating markets where investors might uncover potential opportunities. Read More

   

January 31, 2022 | GSAM Connect

Can Municipal Bonds Handle Higher Rates?

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.

Exhibit 1: Increases in Muni Yields During Fed Tightening Campaigns

Sources: Federal Reserve, Bloomberg, As of Dec. 31, 2021. Yields reflect the maturity buckets of the Bloomberg Municipal Bond Index.

 

And in each hiking cycle, muni returns across various maturity and duration buckets were positive the majority of the time (Exhibit 2). That’s partly because higher yields mean more income, which over time can make up for declines in price.

EXHIBIT 2: Muni Index Returns During Recent Tightening Campaigns

Source: Bloomberg. As of December 31, 2021.

 

Of course, things may work out differently this time. For one thing, muni yields will begin this tightening cycle at lower absolute levels, meaning there is less yield cushion to absorb price declines. Also, valuations and credit spreads are at the tighter end of their historical averages. And the Fed Funds rate is just one factor among many that may influence return potential.

Even so, we don’t think investors should assume that higher rates will definitely mean lower or negative returns. That will vary according to a number of factors, including maturity, investment horizon and overall market conditions. In our view, higher interest rates may provide an opportunity for muni investors to boost return potential by extending duration and strategically deploying cash in the market.

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Municipal Outlook 2022: The Journey Home
With interest rates projected to head higher and credit spreads at the lower end of historical averages, we believe it is time for investors to pare credit risk back to neutral and re-visit their core municipal allocation by opportunistically extending duration and strategically deploying cash. Learn more in our Municipal Fixed Income Outlook 2022.