February 6, 2016
After all the hand-wringing over higher rates and Fed tightening, municipal bond yields were virtually unchanged over the course of 2015. As a result, 2015 turned out to be a solid year for municipal bonds based on both relative and absolute returns. In fact, municipal bonds generated some of the best returns in fixed income during 2015.
Last year, we were constructive on munis for several reasons. First, high-grade municipal bonds entered the year yielding over 100% of the comparable Treasury, even before taxes were taken into account. Oversupply caused this relative “cheapness” and created the backdrop for relative outperformance when technical factors normalized. Second, given subdued economic growth and weaker inflation readings, we believed that long rates were unlikely to rise as much as some market participants feared. Finally, with tax rates over 40% for the highest earners, municipal bonds provided an efficient means of generating income for many investors.
Although much of 2015 played out according to plan, we experienced periods of elevated volatility and suspect that 2016 will provide a much bumpier ride for all investors. The Fed has assured investors that they have a plan to normalize interest rates despite the fact that they have never raised rates from zero. To us, the Fed’s belief that they can “adjust the dials” in just the right way suggests overconfidence. We believe the Fed is trying to play tackle football in a china shop. No matter how careful they are, it is highly likely that they will break something before the game is over. If the market’s reaction to the Fed’s first rate increase in December is any indication, pushing rates higher will be anything but easy.
Looking ahead to 2016, we remain constructive on the municipal asset class given high tax rates and an anticipated robust demand. Still, conditions are somewhat less favorable relative to the beginning of last year. Munis are not as “cheap” when compared to Treasuries due to a significant falloff in supply in the final months of 2015 and an uptick in mutual fund inflows. As the Fed continues to communicate around their normalization strategy, volatility should rise as markets protest the end of endless accommodation. When interest rates are low, there is a tendency for some investors to lose sight of the important role that fixed income plays in their overall portfolio. Given the recent selloff in risk assets, high-quality fixed income has proven yet again that it can serve as a buffer in turbulent times. We believe this is a time to be cautious on risk, and sacrificing some yield for liquidity and flexibility seems like a sensible trade-off.