Amid a careening stock market and dire warnings about the economy, some investors are skittish about adding to their municipal bond holdings.
The constant drumbeat of negative news has them wondering why it would make sense to invest in long-term bonds as the Federal Reserve Board continues to raise rates.
What’s more, they ask, wouldn’t a recession drive up bond defaults?
We understand their wariness, but take issue with their conclusions.
Dim news drives sentiment
Indeed, some high-profile companies are warning about persistent supply chain issues and dimming profits. Inflation is near a four-decade high, while spending by consumers is up in some areas but declining in others.
Yet unemployment is near 50-year lows and demand for workers remains robust.
Following a common definition, we’re already in a recession, though many economists say there are other relevant factors that make it less clear.
Fed mandate clear
The Fed, meantime, is laser focused on taming inflation.
Policymakers are expected to announce a third consecutive 75-basis-point increase in the federal funds rate at their meeting this week. It would mark the fifth hike this year.
The Fed’s aggressive actions have prompted some municipal bond investors to question the wisdom of investing in long-term bonds.
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What they’re missing is context. The Fed has signaled its intention to ultimately raise short-term rates to between 3.75% and 4% next year. That assumption is already built into long-term rates, and Fed hikes until then aren’t likely to greatly affect them.
Further, the federal funds rate is currently 2.25% to 2.50%, so we could be nearing the end of rate hikes.
Finally, the 2-to-10-year yield curve is inverted. As some commentators have pointed out, in the last three interest-rate hike cycles, the Fed has ceased bumping rates by an average of four months – and we’re two months into this cycle.
Aside from the Fed’s actions, still-skeptical investors point out, we’re still in a precarious economic environment. Couldn’t there be an increase risk in defaults?
As longtime investors know, there’s little drama in the municipal bond market (“Amid Turbulence, Muni Bonds Remain Steady”). Defaults are extremely rare, and have been, for decades.
Most states are expected to exceed or meet their general fund estimates. As one report stated, “State and local income tax revenues have risen at a velocity not seen in 20 years.”
Adding to their municipal bond holdings
We’re not soothsayers and don’t pretend to be. No one can accurately predict how the economy will perform or how the Fed will act.
What we’ve seen, however, is investors fleeing the bond market early this year only to return when they realized they were acting on headlines, not the fundamental strength of their munis.
With attractive yields and a sentiment toward less risky investments, we expect reluctant investors to continue their trek back into munis and veteran investors to focus on what they always have: the fundamental quality of their bonds.
