It’ll be no surprise when the Federal Reserve Board raises short-term interest rates over the next few months, but the fallout may shock some people.
For as long as the Fed has signaled its intentions, many soothsayers have predicted that bond prices – which move in the opposite direction of yields – will fall. Therefore, they say, municipal bond investors should be wary.
We say, let’s examine the assumptions behind that notion.
Fed focuses on short-term interest rates
Take a look, for example, at the most recent periods of rate hikes, 1999, 2004 and 2015. In each case, bond prices have edged up afterward.
A key factor is probably because munis are usually longer-term bonds whose prices tend to change before and after the Fed begins hiking rates, according to an analysis by Charles Schwab.
In previous rate-hike cycles, yields on longer-term muni bonds rose in the short term. In the last three rounds of hikes, however, longer-term rates initially went higher (and prices declined) but within months, long-term yields actually fell below where they were before the Fed started raising short-term rates.
As we’ve pointed out (“Fed Rates Debate Masks What’s Important to Muni Investors”), the Fed influences very short-term interest rates. This has the effect of slowing the economy, which means long-term yields – of most concern to municipal investors – decline.
Each rate-hike cycle is unique, so it’s impossible to accurately predict precisely how a Fed rate increase would impact municipal bonds. However, the aftermath of recent bumps suggests the fevered voices will once again be wrong.
This analysis is consistent with our experience. We have always been advocates of long-term bonds (“Looking to succeed in the Municipal Bonds Market?”). It’s invariably where investors find the highest yields and the most tax-free income.
Waiting for the Fed can be costly
Investors lose ground when they try to time the market based on events that may or may not occur at a time that no one knows. Too often, they park their cash in money-losing money-market accounts and avoid munis until the illusory “right time.”
Meantime, they deprive themselves of a steady flow of tax-free income – the primary objective of municipal investing – and jeopardize a good night’s sleep.
Investors waiting for the Fed to take action before finding suitable municipal bonds are shortchanging themselves. Attempting to predict the future direction of long-term interest rates is an exercise in futility.