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Rising Interest Rates and
Municipal Bond Performance
While yield curve forecasting has historically been a fool’s errand, we recognize that yields today remain at all-time lows and the prospects for total return from fixed income portfolios are more unfavorably skewed today than at any time over the last 30 years. However, we believe a fixed income allocation remains critical to investors seeking stable income streams, a balanced asset allocation, or as a potential buffer to portfolio volatility. Investors
beholden to traditional investment-grade fixed income securities must continue to grapple with interest rate risk, credit risk, liquidity risk and sector risk. We believe tax-exempt bond investors, who are subject to certain factors unique to the municipal bond market, may outperform their counterparts in other fixed income sectors on an after-tax basis even in the face of rising interest rates.
WHERE ARE DOMESTIC INTEREST RATES HEADED?
The structure of the inquiry is simple. Where are interest rates headed? Efforts to provide an answer have resulted in much toil, sweat, and many tears over the last decade.1 If only more participants would observe the discretion in
Mark Twain’s answer to a question from river boat pilot Mr. Bixby during their travels on the Mississippi and simply confess, “I don’t know.”2
In fact, no one can know with certainty. Market participants are unable to correctly forecast the supply and demand for any class of bonds in the near term, let alone long term. There are too many inputs to the analysis.
September 2013
INTRODUCTION
Fixed income investors are justifiably anxious about recent increases in
long-term bond yields. Much of the yield spike has been attributed to
comments from the Federal Reserve Bank concerning its quantitative
easing (QE) program and the potential for a tapering of U.S. Treasury bond
purchases, but certainly other factors may also influence rate levels.
Regardless of the cause, investors have taken these events as an opportunity
to consider the impact of rising interest rates on portfolio holdings.
Adam Mackey
Managing Director
Municipal Fixed
Income
I was gratified to be able to answer promptly, and I did. I said I didn’t know.
2 Rising Interest Rates and Municipal Bond Performance
As an example, consider the demand for U.S. bonds. Domestic demand ebbs and flows as pensions seek returns that will improve their funding levels, while at the same time reducing the volatility of plan funding ratios; seniors search for yield that will support their immediate needs, while offering growth for needs later in retirement; all while banks load up on certain obligors in order to improve their capital ratios. Then, sovereign debt investors lose faith in Spain’s or Italy’s ability to pay obligations and sell their debt holdings from both countries. Money flows into U.S. Treasury bonds, thereby increasing demand for the benchmark bond in the U.S. fixed income market, forcing rates down.
Next, U.S. employment numbers indicate a soft labor market and the chance for extended economic distress. The Federal Reserve initiates yet another operation to purchase long-dated bonds indefinitely or until unemployment falls below an arbitrary threshold. This further increases demand for U.S. dollar-denominated bonds, pushing rates even lower. Whose model is calibrated for that sequence of events? For the next crisis? For the timing of the resolutions? And that’s just a portion of the demand side. How will an increase in economic growth, the eventual tapering of QE, an onset of inflation, or the effects of the Great Rotation out of bonds and into other asset classes affect rates?
We propose that instead of a preoccupation with yield-curve forecasting, investors would be better served by a deeper understanding of the relative risks of fixed income bonds. Coupon structures, security types, embedded options, future tax policy, and underlying project or obligor financial condition are factors that investors can monitor and use to express a view in fixed income portfolios. We will discuss five principal conditions specific to the municipal market supporting our opinion that municipal bonds will outperform other fixed income sectors in a rising interest rate environment.
PREMIUM COUPON AND PRICE PROTECTION
Convention in most fixed income sectors requires that
coupons be set such that bonds are priced at par when issued. This pricing model is not the case for the municipal bond market. For years, the standard coupon, regardless of obligor credit or benchmark rate, has been 5.00%. As a result, nearly all the investment-grade bonds in the municipal market trade at premium prices.3 While some investors express an aversion
to paying more than par for a bond, there is an upside: relative price protection in a rising rate environment.
Consider two bonds maturing in 10 years, one with a 5.00% coupon priced at 127.055, and the second priced at par and yielding 2.09%, reflective of the 10-year benchmark curve.4
Table 1 holds a summary of returns on each bond in the event of a parallel shift up in the benchmark yield curve. Six scenarios are considered, each an additional 25 basis point (bp) parallel shift in the yield curve. As the results demonstrate, while returns on both bonds are negative, the premium bond performs better than the par bond under each yield curve scenario. To cite one result, the 5.00% bond
outperforms the 2.09% bond by 83 bps in the event of a 100 bps shift in the benchmark yield curve.5
CALL OPTIONS AND PRICE PROTECTION
A call option on a bond provides the issuer the right to retire the bond prior to its maturity at a fixed price, typically at par. Consider our 2.09% bond alongside a bond issued 10 years ago with a 20-year maturity, a coupon of 2.09% (a match to our par bond), a first call date of May 31, 2013, and a call price of 100.00. So, as of today both bonds have 10 years to maturity and a 2.09% coupon, but the callable bond is currently
callable at par.
Table 2 shows the performance of the bonds under the same yield curve scenarios presented in the previous section. Once again, we see that the benchmark bond underperforms relative to the alternative structure. In this case, in the event of only a 50 bps parallel shift in the yield curve, the callable bond will outperform the non-call bond by 53 bps.6
PREMIUM CALLABLE BONDS
AND PRICE PROTECTION
Among all the characteristics that set the municipal bond market apart from other fixed income markets, the availability and liquidity of premium callable bonds are striking. As we stated above, since most municipal bonds bear a 5.00% coupon, most will trade at a premium. Additionally, bonds with maturities in excess of 10 years typically bear embedded call options at issue. So, many municipal investors will already hold premium callable bonds in their portfolios. In general, a 5.00% coupon bond will likely be called in a 2% yield environment, since the issuer can save 3% per year for every year left to maturity by refunding the bond at the lower prevailing yield. Not surprisingly, this option affects the bond’s price.
We argue despite the potential for the bond to be called from the owner, there is a benefit to this structure in a low-rate environment. Consider our representative 2.09% non-call bond next to two 5.00% callable bonds due in 2023, one currently callable at par in 2013 and the second callable at
Table 1: Effect of Coupon Levels on Bond Return4
Bond Structure
5.00% due 05/31/2023
Yield Curve Shift
+25 +50 +75 +100 +125 +150
-2.08 -4.10 -6.08 -8.01 -9.89 -11.73
2.09% due 05/31/2023 -2.29 -4.53 -6.71 -8.84 -10.91 -12.93
Advantage 0.21 0.43 0.63 0.83 1.02 1.20
Table 2: Effect of Call Options on Bond Return4
Bond Structure
2.09% Callable 2013
Yield Curve Shift
+25 +50 +75 +100 +125 +150
-1.89 -4.00 -6.14 -8.25 -10.32 -12.35
2.09% due 05/31/2023 -2.29 -4.53 -6.71 -8.84 -10.91 -12.93
par in 2018. The performance for each bond under our yield curve scenarios is presented in Table 3.
In the low-rate environment we have described, where the 10-year rate is 2.09%, the 5% bond that is currently callable will be called and refunded at the lower yield. It does not matter if the yield curve shifts up 25 bps, 50 bps, or 150 bps. In a rising rate environment, the bond will generate 0% return across the shifts we have considered, generating the line we see in Table 3 indicating a 0% return level.
Deep in-the-money, currently callable bonds do not represent a long-term investment option; they are going to be called. But a 10-year, 5.00% coupon bond callable in five years (2018) can still provide an investor with some price protection under rising rate scenarios. In Table 3, the bond callable in 2018 generates a loss of -5.53% in the event of a 100 bps parallel shift up in the yield curve. The 2.09% non-callable bond generates a significantly larger loss of -8.84% under the 100 bps shift scenario. Even though investors do not own the call options on their bonds, these options can still prove a benefit to bondholders under the conditions to which we are subject in today’s fixed income markets.
THE RATIO OF MUNICIPAL BOND YIELDS
TO U.S. TREASURY YIELDS
Consider the yield offered on a taxable versus a tax-exempt bond. All else equal, including the size, timing, and riskiness of the cash flows to be received from the bonds, the tax-exempt bond should offer a lower yield than its taxable counterpart, since no tax is owed on the coupon interest. This relationship is typically depicted as a ratio in the municipal bond market, tax-exempt yield over taxable yield.
Chart 1 provides the history of the 10-year yield for the U.S. Treasury market against the AAA-rated General Obligation (GO) yield curve generated by Municipal Market Data
(MMD), commonly referred to as the AAA MMD curve. It is a benchmark curve for the municipal market, representing the best credits available to investors. In this case, end-of-month data are provided for the last 10 years.
For each end-of-month pair of rates, we calculate a ratio, the values of which are represented on the right-hand axis of the chart. The highest value for the ratio during the 10-year period is almost 158% (December 31, 2008), with a low just over 77% (December 31, 2009…what a difference a year makes). The average value of the ratio for the 120 periods was 91.47%, with a standard deviation of 12.26%. At the end of May 2013, the ratio stood at 97.66%.
In a certain world, the ratio would reflect the marginal tax rate of the average investor in the municipal market. So we might expect a ratio of 69% if the average marginal tax rate was 31%. While our look back over the last 120 months does not offer a figure as low as 69%, it is certainly possible that we will see a fall from almost 98% back to an 80% ratio.
In the event that the U.S. Treasury rates remain fixed at present levels and the municipal yield curve shifts lower to reflect a ratio falling towards 80%, the potential gains to municipal bond holders will be substantial, as detailed in Chart 2. A move to a 91% ratio would generate a price return on a 10-year, 5.00% municipal bond of 1.31%. A fall to 80% would generate a return of nearly 3.60%. Given the high level of uncertainty surrounding the tax exemption for municipal bonds that exists today, any resolution of the uncertainty has the potential to drive stronger demand and potentially provide municipal investors with substantial upside return, even in the face of rising rates.
MUNICIPAL-TO-TREASURY YIELD BETA
The relationship between the historical changes in U.S. Treasury rates and changes in AAA tax-exempt rates provides additional evidence that tax-exempt bonds have significant potential to outperform their taxable cousins in a rising rate environment. We draw this conclusion from some statistical analysis of the data points previously shown in Chart 1. We start with the month-to-month change in the 10-year rate from each data set.7 These new data points are plotted in
Chart 3. Casual observation indicates a positive relationship
Table 3: Effects of Call & Coupons on Bond Return4
Bond Structure
5.00% Callable 2018
Yield Curve Shift
+25 +50 +75 +100 +125 +150
-1.32 -2.64 -4.09 -5.53 -6.95 -8.46
2.09% due 05/31/2023 -2.29 -4.53 -6.71 -8.84 -10.91 -12.93
Advantage 0.97 1.89 2.62 3.31 3.96 4.47
5.00% Currently Callable **Bonds will be called; Return is 0%**
Chart 1: Historical Look at 10-Year Rates4
10 Yr AAA GO
Yield (%)
Ratio (%)
1.25
Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13
1.75 2.25 2.75 3.25 3.75 4.25 4.75 5.25 5.75 75.00 85.00 95.00 105.00 115.00 125.00 135.00 145.00 155.00 165.00
10 Yr UST AAA GO/UST Ratio
Chart 2: Effect of Muni/UST Ratios on Bond Return4
0.0 1.0 2.0 100% 0.00 1.31 2.55 3.58 Return on Bond (%) 91% 85% 80% 3.0 4.0
4 Rising Interest Rates and Municipal Bond Performance
between changes in the U.S. Treasury yield (x-axis) and AAA tax-exempt yield (y-axis), with the data points sloping upward to the right in the chart. As expected, there are some outliers, with several observations where one of the yields moved one way, its counterpart moved the other way.8
A statistical technique known as regression analysis allows us to generate a “line of best fit” through the data points. This is the upward sloping line that cuts through the middle of the cloud of data in the chart. The slope of this line is commonly referred to as “beta.” Since our data are yields, the slope of the line represents the yield beta. The analysis reveals that the yield beta is 0.52, indicating for every 1% change in the 10-year U.S. Treasury yield, we expect the 10-year tax-exempt yield to shift 0.52%.9
If the past is any indication, then during a month when yields are rising, tax-exempt yields will move only about half as
much as the taxable benchmark U.S. Treasury yield. All else equal, the percentage change in price for tax-exempts, while negative due to higher yields, will be less than that for taxable bonds priced off the U.S. Treasury curve.
CONCLUSION
Risk can be generically defined as the probability that actual outcomes differ from expectations. This translates quite well to the situation we face in fixed income markets today. We cannot resolve the risk associated with fixed income investing, but we can take action to reduce it under various scenarios. That is, we can reduce the probability that actual outcomes differ from expectations for given scenarios. Tax-exempt premium coupon bonds with embedded call options and yields near or above U.S. Treasury rates can offer price protection in a rising rate environment relative to non-callable par-priced taxable bonds. Municipal interest rates at nominal levels of greater than 100% of comparable U.S. Treasury, agency, and U.S. corporate securities present an opportunity for significant outperformance. Finally, if Congress provides clarity around federal deficit reduction plans and future tax policy, municipal bonds could experience price appreciation. Currently there is not a nominal yield penalty for holding municipal bonds as current yield levels indicate full taxation of municipal interest.
Investors should give serious consideration to the range of municipal bond investments available to them prior to exiting fixed income investments entirely. Disregarding such options may prove hazardous to their wealth.
Chart 3: Change in 10-Yr Yields & Regression Line4
-1.05 -0.75 -0.45 -0.15 0.15 0.45 0.75 1.05 -0.45 -0.75 -1.05 0.15 0.45 0.75 1.05 Change in 10-Y r AAA MMD Y eild
Change in 10-Yr UST Yield
1 Much has been made of comments by PIMCO’s Bill Gross concerning the end of the bull market in U.S. Treasury bonds. For example, see http://online.wsj.
com/article/SB10001424127887324244304578475362960355082.html, which summarizes Mr. Gross’s calls of a top in December 2001, November 2010, and, most recently, May 2013.
2 Readers looking for a more affirmative response on the direction of bond yields may do well to borrow a comment from JP Morgan. When asked what the
stock market would do, he responded, “It will fluctuate.” As will yields.
3 Premium bonds are defined as fixed income securities with a current price that exceeds par value, where par is the amount returned to the investor
at maturity.
4 As of May 31, 2013. Yield curve data for valuation and coupon setting are from Thomson-Reuters Municipal Market Data (MMD).
5 Recent market activity supports these results. See, for example, Ramage, James, “In Selloff, Higher Coupons Outperformed,” The Bond Buyer, vol. 385, no.
33939, July 3, 2013.
6 Note that in the case of the callable bond, the advantage appears to be almost fully realized after just a 50 bp shift. This is due to the fact that, in effect, the
callable bond acts like a non-call when the bond’s coupon is well below the benchmark, as is the case as benchmark rates rise.
7 Recall, the data in Chart 4 consist of the 10-year U.S. Treasury yield and the 10-year AAA MMD yield at the end of each month over a 10-year period, a total
of 120 observations. In calculating the change from one month to the next, we arrive at 119 monthly changes.
8 These 21 data points are found in the NW and SE quadrants of the chart. The most extreme observation is taken from end of December 2008 to end of
January 2009, a month over which the Treasury yield rose 0.61% and the municipal yield fell 0.58%.
This publication is for informational purposes only and reflects the current opinions of PNC Capital Advisors, LLC. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice, a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected by the author on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities identified do not represent all of the securities purchased, sold or recommended and it should not be assumed that any listed securities were or will prove to be profitable. Indices are unmanaged and not available for direct investment. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. Past performance is no guarantee of future results.
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