In theory, municipal bonds are supposed to be one of the least eventful asset classes around, fixed income or otherwise. Munis, broadly speaking, don't have reputations for volatility.
That's one of the reasons why the asset class has long been favored by advisors as an income-generating tool for older, conservative clients, particularly those in retirement. Yields are typically low on municipal bonds, but so is risk and that's a trade-off clients in certain demographics are comfortable embracing.
Leave it to the Federal Reserve to throw a wrench in well-intended fixed income plans. The Fed's first rate hike of 2022 could arrive as soon as next month and that's likely to mark the start of a multi-hike tightening regime spanning into next year, perhaps into 2024.
The Fed is forecasting as many as four rate increases this year. Some experts believe it could be more. Regardless of what the final tally is, the central bank is signaling rate hikes are necessary to damp inflation and bond markets are reacting, including the massive municipal bond segment.
Muni Challenges and Opportunity
Municipal bonds' start to 2022 was the worst start to a year for the asset class in more than two decades. The problem is that short-term interest rates are rapidly rising while long-term rates are merely inching higher.
“Why? A result of the declaration by the Fed; when they raise rates, it is specifically the short end of the Treasury curve where this change happens, while the long end is left to adjust to market forces,” says VanEck Municipal Bond Strategist Jim Colby. “The relatively small adjustment at the end of the yield curve suggests that the impact of inflationary forces are not a long- term concern.”
As Colby notes, the aforementioned scenario is what's known as a bear flattener environment. Predictably, the Fed is the culprit here and it's rate hiking plans are pressuring the municipal bond market.
“The near-term catalyst for change is the Federal Reserve. Whether they end the stimulus gradually or with a sudden stop, their policy has already set in motion changes for the market and country that will influence investment decisions. Their declaration of as many as four rate increases in 2022 acknowledges that both the pressures of inflation and the characteristics of a changing economy must not be ignored,” adds Colby.
While this is clearly a trying time for bond investors, the case for municipal bonds isn't dead. Clients may feel way that way, but they likely aren't aware of where to be with munis. That's where advisors come in.
Muni Plan of Attack
There are options for remaining engaged with municipal bonds in the current environment. Those includes remaining invested and riding out rate hikes or focusing on duration in an effort to avoid munis and funds that are sensitive to higher rates.
“We have been in an exceedingly low rate environment for many months, and the current adjustments mean that investments in the municipal market will be at more appealing rates. Where exactly to look to for the best outcome is evolving,” concludes Colby.
Ideas for advisors in terms of addressing munis with clients include high-yields bonds, which are relatively safe owing to improving state finances, and intermediate-term munis.