Muni Strategy Amid The Inverted Yield Curve

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<h3>James A. Klotz</h3>

James A. Klotz

When the Fed raised interest rates last year, we cautioned municipal bond investors it wasn’t what it seemed.

We knew many investors, trying to time the market, were looking for a signal to jump back into munis. They parked their cash in money-losing money-market funds and waited for rates to rise.

We figured those investors would see the Fed move as a signal that the economy was heating up and long-term rates would soon soar. If they waited just a bit longer, they thought, their plan would work to perfection.

Once again, those “market-timing” investors were mistaken.


Perils of following the Fed

In an era when TV financial shows and online media are saturated with market prognosticators, many investors mistakenly believe the Fed controls rates across all time horizons.

But the Fed only affects the shortest of interest rates. As we pointed out at the time (“Muni Investors Missing the Sign from Fed Chief”), long-term rates – the rates municipal bond investors focus on – are determined by market forces, chiefly the buying and selling of Treasury bonds.

The Fed’s move in December, wasn’t a harbinger of a roaring economy. In fact, plenty of signs pointed in the opposite direction.

As we’ve seen, long-term rates have indeed plummeted and the yield curve briefly inverted. That is, short-term yields exceeded long-term yields, a phenomenon that generally precedes a recession.

Today, bond markets around the world are in turmoil, as the debt of several countries – $15 trillion worth – is trading at negative yields.

Yes, negative yields.

Buying a German or Japanese bond will return less at maturity than face value.

Inverted yield curve dramatic, not surprising

Back at the end of 2017, as we pointed out (“What Muni Investors Should Know About the New Fed Head”), the market presaged the inverted yield curve, as the spread between the 10- and 2-year Treasury yields was at its slimmest margin in a decade.

Now, in the past few days, the 10-year Treasury has scraped below 1.5%, a three-year low, and the 30-year Treasury fell below 2.0% for the first time ever.

Investors reading tea leaves are surprised; those who understand the market – the ones who keep it simple – are not.

How does the muni market look today?

Predictably, investors are plowing funds into municipal bonds. After all, there’s no comfort in equities; due to unprecedented volatility, and it appears the days when lower bond yields indicate higher stock prices are behind us.

In comparison to other fixed income investments, munis have been particularly attractive this year as investors began to feel the effects of the tax overhaul. Now economic uncertainty is driving a flight to safety.

The inverted yield curve and other developments prove, once again, the folly of trying to predict the future. They reinforce the simple, time-tested strategy of looking for quality and value, regardless of market noise.

For those who’ve failed to learn and scoff at today’s yields, they should understand, high-quality municipal bonds are yielding 2.75% to 3.00% – while taxable 30 year Treasury bonds are hovering around 2.00%.

Muni bonds are a steal.

James A. Klotz is the President of FMSbonds, Inc.
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Aug 19, 2019

Please note that all investing entails risk. Fixed income securities are subject to risks that will affect their value prior to maturity. Some of these risks can be related to changes in market conditions, issuer creditworthiness, and interest rates. This commentary is not a recommendation to buy or sell a specific security. All references to tax-free income refer to U.S. federal income tax. Income earned by certain investors may be subject to the Alternative Minimum Tax (AMT), and or taxation by state and local authorities. Please consult with your tax professional prior to investing. For more information on these topics please click on the “Bond Basics” link below or search by keyword at the top of this page.