Believe it or not, any domestic bond trader under the age of 55 has never traded in a bond bear market. Unlike the stock market, which tends to cycle between bull and bear markets every five to ten years, bond markets can go decades trending in one direction. These long periods of predictable rate movements may seem easy to trade, especially in hindsight, but when the trend changes, muscle memory can trump logic leaving many traders and investors offside.

If you believe higher yields are upon us in the near future, there are many ways to protect your bond portfolio. In this article, we present one idea applicable to municipal bonds. The added benefit of this idea is it does not detract from performance if rates remain stubbornly low or fall even lower.  Who says there is no such thing as a free lunch?

Munis

Municipal bonds, aka Munis, are debt obligations issued by state and local government entities. Investors who seek capital preservation and a dependable income stream are the primary holders of munis. In bear markets, munis can offer additional yield over Treasury bonds, still maintain a high credit quality, and avoid the greater volatility present in the corporate bond or equity markets.

Munis are unique in a number of ways but most notably because of their tax status. Please note, munis come in taxable and tax-exempt formats but any reference to munis in this article refers to tax-exempt bonds.

Because of their tax status, evaluating munis involves an extra step to make them comparable to other fixed income assets which are not tax-exempt. When comparing a muni to a Treasury, corporate, mortgage backed security, or any asset for that matter, muni investors must adjust the yield to a taxable equivalent yield. As a simple example, if you are in a 40% tax bracket and evaluating a muni bond yielding 2%, the taxable equivalent yield would be 3.33% (2.00% / (1-40%). It is this yield that should be used to equate it to other fixed income securities.

Negative “Tax” Convexity Matters

Thus far, everything we have mentioned is relatively straight-forward. Less well-understood is the effect of the tax rate on muni bonds with different prices and coupons. Before diving into tax rates, let’s first consider duration. Duration is a measure that provides the price change that would occur for a given change in yield. For instance, a bond with a duration of 3.0 should move approximately 3% in price for every 1% change in yield.

While a very useful measure to help quantify risk and compare bonds with different characteristics, duration changes as yields change. Convexity measures the non-linear change in price for changes in yield. Convexity helps us estimate duration for a given change in yield.

For most fixed rate bonds without options attached, convexity is a minor concern. Convexity in the traditional sense is a complex topic and not of primary importance for this article. If you would like to learn more about traditional convexity, please contact us.

Munis, like most bonds, have a small amount of negative convexity. However, because of their tax status, some muni bonds have, what we call, an additional layer of negative tax convexity. To understand this concept, we must first consider the complete tax implications of owning munis.

The holder of the muni bond receives a stream of coupons and ultimately his or her invested principal back at par ($100). The coupons are tax free, however, if the bond is sold prior to maturity, a taxable capital gain may occur.

The table below illustrates three hypothetical muni bonds identical in structure and credit quality. We use a term of 1 year to make the math as simple as possible.

In the three sample bonds, note how prices vary based on the range of coupons. Bond A has the lowest coupon but compensates investors with $2.41 ($100-$97.59) of price appreciation at maturity (the bond pays $100 at maturity but is currently priced at $97.59). Conversely, Bond C has a higher coupon, but docks the holder $2.41 in principal at maturity.

For an uninformed investor, choosing between the three bonds is not as easy as it may appear. Because of the discounted price on bond A, the expected price appreciation ($2.41) of Bond A is taxable and subject to the holder’s ordinary income tax rate. The appropriate tax rate is based on a De minimis threshold test discussed in the addendum. Top earners in this tax bracket pay approximately 40%.

Given the tax implication, we recalculate the yield to maturity for Bond A and arrive at a net yield-to-maturity after taxes of 4% (2.50% + (2.50 *(1-.40). Obviously, 4% is well below the 5% yield to maturity offered by bonds B and C, which do not require a tax that Bond A does as they are priced at or above par. Working backwards, an investor choosing between the three bonds should require a price of 95.88 which leaves bond A with an after tax yield to maturity of 5% and on equal footing with bonds B and C.

Implications in a rising yield environment and the role of “tax” convexity

Assume you bought Bond B at par and yields surged 2.50% higher the next day. Using the bond’s stated duration of .988, one would expect Bond B’s price to decline approximately $2.47 (.988 * 2.5%) to $97.53. Based on the prior section, however, we know that is not correct due to the tax implications associated with purchasing a muni at a price below par. Since you purchased the bonds at par, the tax implication doesn’t apply to you, but it will if anyone buys the bond from you after the 2.5% rise in yields. Therefore, the price of a muni bond in the secondary market will be affected not just by the change in rates, but also the associated tax implications. Assuming the ordinary income tax rate, the price of Bond B should fall an additional $1.65 to $95.88.  This $1.65 of additional decline in Bond B’s price is the penalty we call negative tax convexity.

The graph below shows how +/- 2.50% shifts in interest rates affect the prices of bonds A, B, and C. The table below the graph quantifies the change in prices per the shocks. For simplicity’s sake, we assume a constant bond duration in this example.

It is negative tax convexity that should cause investors, all else being equal, to prefer bonds trading at a premium (such as bond C) over those trading at par or a discount. It is also worth noting that the tax convexity plays an additional role in the secondary market for munis. Bonds with prices at or near par will be in less demand than bonds trading well above par if traders anticipate a near term rise in yields that will shift the par bond to a discounted price.

Summary

Yields have fallen for the better part of the last thirty years, so muni investors have not had to deal with discounted bonds and their tax implications often. Because of this, many muni investors are likely unaware of negative tax convexity risk. As we highlighted in the table, the gains in price when yields fall are relatively equal for the three bonds but the negative deviation in price in a rising yield environment is meaningful. Given this negative divergence, we recommend that you favor higher coupon/ higher priced munis. If you currently own lower priced munis, it may be worth swapping them for higher priced (higher coupon) bonds.

Addendum: De minimis

The tax code contains a provision for munis called the de minimis rule. This rule establishes the proper tax rate to apply to capital appreciation. The following clip from Charles Schwab’s Bond Insights provides a good understanding of the rule.

The de minimis rule

The de minimis rule says that for bonds purchased at a discount of less than 0.25% for each full year from the time of purchase to maturity, gains resulting from the discount are taxed as capital gains rather than ordinary income. Larger discounts are taxed at the higher income tax rate.

Imagine you wanted to buy a discount muni that matured in five years at $10,000. The de minimis threshold would be $125 (10,000 x 0.25% x five years), putting the dividing line between the tax rates at $9,875 (the par value of $10,000, minus the de minimis threshold of $125).

For example, if you paid $9,900 for that bond, your $100 price gain would be taxed as a capital gain (at the top federal rate of 23.8%, that would be $23.80). If you received a bigger discount and paid $9,500, your $500 price gain would be taxed as ordinary income (at the top federal rate of 39.6%, that would be $198).

It is important to note that some bonds are issued at prices below par. Such bonds, called original issue discount (OID), use the original offering price and not par as the basis to determine capital gains. If you buy a bond with an OID of $98 at a price of $97.50, you will only be subject to $0.50 (the difference between the OID price and the market price) of capital gains or ordinary income tax.

The following speech by Jerome Powell, Chairman of the Federal Reserve, was given on November 28, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below. If you have not read our review of Vice-Chairman Richard Clarida’s speech from yesterday you can find it HERE.

The Federal Reserve’s Framework for Monitoring Financial Stability

Chairman Jerome H. Powell

At The Economic Club of New York, New York

It is a pleasure to be back at the Economic Club of New York. I will begin by briefly reviewing the outlook for the economy, and then turn to a discussion of financial stability. My main subject today will be the profound transformation since the Global Financial Crisis in the Federal Reserve’s approach to monitoring and addressing financial stability. Today marks the publication of the Board of Governors’ first Financial Stability Report. Earlier this month, we published our first Supervision and Regulation Report. Together, these reports contain a wealth of information on our approach to financial stability and to financial regulation more broadly. By clearly and transparently explaining our policies, we aim to strengthen the foundation of democratic legitimacy that enables the Fed to serve the needs of the American public.

Outlook and Monetary Policy
Congress assigned the Federal Reserve the job of promoting maximum employment and price stability. I am pleased to say that our economy is now close to both of those objectives. The unemployment rate is 3.7 percent, a 49-year low, and many other measures of labor market strength are at or near historic bests. Inflation is near our 2 percent target. The economy is growing at an annual rate of about 3 percent, well above most estimates of its longer-run trend.

For seven years during the crisis and its painful aftermath, the Federal Open Market Committee (FOMC) kept our policy interest rate unprecedentedly low–in fact, near zero–to support the economy as it struggled to recover. The health of the economy gradually but steadily improved, and about three years ago the FOMC judged that the interests of households and businesses, of savers and borrowers, were no longer best served by such extraordinarily low rates. We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth. My FOMC colleagues and I, as well as many private-sector economists, are forecasting continued solid growth, low unemployment, and inflation near 2 percent.

RIA Pro comment– In these first two paragraphs Jerome Powell points out that the economy is running above its longer-term trend in large part due to the support of “near zero” interest rates (Fed monetary policy). Given recent above-trend economic growth and a sustained recovery from the financial crisis, the Fed raised rates to get to a less simulative level.

He states that “interest rates are still low by historical standards” and “remain just below” what they would consider neutral for the economy. The phrasing “remain just below” is the key line from the speech as it was only a month ago, on October 3^rd, when he said they were a “long way” from neutral. In no uncertain terms, this abrupt change in posture is a clear signal to the market that the Fed may be close to ending their hiking cycle.

There are two other important points regarding the neutral rate worth discussing. First, the Federal Reserve does not know with any real precision what the “neutral” rate of interest for the economy is or should be. This is best left to un-manipulated markets and the independent buyers and sellers that drive them. Second, if indeed Powell and the Fed did know with certainty where the neutral rate should be, it likely would not be at a real rate near zero, with economic growth running above 3% and the unemployment rate at 50 year lows as is currently the case.

There is a great deal to like about this outlook. But we know that things often turn out to be quite different from even the most careful forecasts. For this reason, sound policymaking is as much about managing risks as it is about responding to the baseline forecast. Our gradual pace of raising interest rates has been an exercise in balancing risks. We know that moving too fast would risk shortening the expansion. We also know that moving too slowly–keeping interest rates too low for too long–could risk other distortions in the form of higher inflation or destabilizing financial imbalances. Our path of gradual increases has been designed to balance these two risks, both of which we must take seriously.

We also know that the economic effects of our gradual rate increases are uncertain, and may take a year or more to be fully realized. While FOMC participants’ projections are based on our best assessments of the outlook, there is no preset policy path. We will be paying very close attention to what incoming economic and financial data are telling us. As always, our decisions on monetary policy will be designed to keep the economy on track in light of the changing outlook for jobs and inflation.

RIA Pro comment- Powell is parroting the substance of Clarida’s speech yesterday essentially saying that the Fed is no longer on rate-hiking auto-pilot. They will raise rates or abstain from raising rates based on what economic and financial data tell them (data dependency). As we mentioned yesterday, the increased emphasis on data dependency by definition reduces their reliance on forward guidance which will introduce more volatility to the markets. Prior reliance on forward guidance helped suppress volatility, so it follows that less reliance on it will make them less predictable and naturally raises the level of uncertainty for investors.

Under the dual mandate, jobs and inflation are the Fed’s meat and potatoes. In the rest of my comments, I will focus on financial stability–a topic that has always been on the menu, but that, since the crisis, has become a more integral part of the meal.

We omitted the rest of the speech as its focus is a historical perspective of financial stability and less relevant to current monetary policy. The entire speech can be found HERE

RIA Pro Summary

It is clear from this speech, as well as recent trial balloons put out by the Fed, that they are taking a more dovish stance. This does not mean they will halt their rate hikes, but in our opinion it is clear that once we move beyond the scheduled hike in December, all bets are off the table. Barring signs of wage growth, stronger inflation or sustained economic growth above 3%, they are unlikely to raise rates further.

The stock market rocketed higher on what is perceived as a dovish speech with the strong possibility that Fed hikes will be halted come 2019. Time will tell if the gains are sustainable and if the market is interpreting his speech correctly. It is worth mentioning however that a recession followed the last three times that the Fed Funds rate hit a cycle high. 

The Following Speech by Richard Clarida, Vice Chairman of the Federal Reserve, was given on November 27, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. More specifically, given Clarida’s role as the Vice Chairman, he is one of the main sources of communicating whether the Fed is indeed considering reversing to a more dovish stance in the months ahead. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below.

Data Dependence and U.S. Monetary Policy

Vice Chairman Richard H. Clarida

At The Clearing House and The Bank Policy Institute Annual Conference, New York, New York

I am delighted to be speaking at this annual conference of the Clearing House and the Bank Policy Institute. Today I will discuss recent economic developments and the economic outlook before going on to outline my thinking about the connections between data dependence and monetary policy. I will close with some observations on the implications for U.S. monetary policy that flow from this perspective.

Recent Economic Developments and the Economic Outlook
U.S. economic fundamentals are robust, as indicated by strong growth in gross domestic product (GDP) and a job market that has been surprising on the upside for nearly two years. Smoothing across the first three quarters of this year, real, or inflation-adjusted, GDP growth is averaging an annual rate of 3.3 percent. Private-sector forecasts for the full year–that is, on a fourth-quarter-over-fourth-quarter basis–suggest that growth is likely to equal, or perhaps slightly exceed, 3 percent. If this occurs, GDP growth in 2018 will be the fastest recorded so far during the current expansion, which in July entered its 10th year. If, as I expect, the economic expansion continues in 2019, this will become the longest U.S. expansion in recorded history.

Likewise, the labor market remains healthy. Average monthly job gains continue to outpace the increase needed to provide jobs for new entrants to the labor force over the longer run, with payrolls rising by 250,000 in October. And, at 3.7 percent, the unemployment rate is the lowest it has been since 1969. In addition, after remaining stubbornly sluggish throughout much of the expansion, nominal wage growth is picking up, with various measures now running in the neighborhood of 3 percent on an annual basis. 

The inflation data in the year to date for the price index for personal consumption expenditures (PCE) have been running at or close to our 2 percent objective, including on a core basis‑‑that is, excluding volatile food and energy prices. While my base case is for this pattern to continue, it is important to monitor measures of inflation expectations to confirm that households and businesses expect price stability to be maintained. The median of expected inflation 5-to-10 years in the future from the University of Michigan Surveys of Consumers is within–but I believe at the lower end of–the range consistent with price stability. Likewise, inflation readings from the TIPS (Treasury Inflation-Protected Securities) market indicate to me that financial markets expect consumer price index (CPI) inflation of about 2 percent to be maintained. That said, historically, PCE inflation has averaged about 0.3 percent less than CPI inflation, and if this were to continue, the readings from the TIPS market would indicate that expected PCE inflation is running at somewhat less than 2 percent.

RIA Pro comment– Clarida believes the economy is growing at a healthy clip and wage growth is relatively strong in the 3% range. These statements by themselves argue that the Fed is woefully behind the curve in raising rates. Based on historical precedence, one would expect Fed Funds to currently reside in the 3.50-5.00% range versus the current 2.25%. One explanation for the low Fed Funds rate, as Clarida implies, is that inflation and inflation expectations remain low. In the next two paragraphs, he goes on to explain why inflation may remain low and not rise to levels that would overly concern the Fed.

What might explain why inflation is running at or close to the Federal Reserve’s long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust? According to the Bureau of Labor Statistics, productivity growth in the business sector, as measured by output per hour, is averaging 2 percent at an annualized rate this year, while aggregate hours worked in the business sector have risen at an average annual rate of 1.8 percent through the third quarter. This decomposition–in which the growth in output is broken down into measures of aggregate supply, the growth of aggregate hours and the growth of output per hour–suggests that the growth rates of productivity and hours worked in 2018 each have been exceeding their respective longer-run rates as estimated by the Congressional Budget Office. In other words, while growth in aggregate demand in 2018 has been above the expected long-run growth rate in aggregate supply, it has not been exceeding this year’s growth in actual aggregate supply.

Ultimately, hours growth will likely converge to a slower pace because of demographic factors. But how rapidly this happens will depend in part on the behavior of labor force participation. And recent years’ developments suggest there may still be some further room for participation in the job market‑‑especially in the prime-age group of 25-to-54-year-olds‑‑to rise. Labor participation by prime-age women has increased around 2 percentage points in the past three years and is now at its highest level in a decade. That said, it is still 1-1/2 percentage points below the peak level reached in 2000. Labor force participation among 25- to 54-year-old men has risen by roughly 1 percentage point in the past several years. But it is still 2 percentage points below levels seen a decade ago, and it is 3 percentage points below the levels that prevailed in the late 1990s.

As for productivity growth, there is considerable uncertainty about how much of the rebound in productivity growth that we have seen in recent quarters is cyclical and how much is structural. I believe both factors are at work. The structural, or trend, component of productivity growth is a function of capital deepening through business investment as well as a multifactor component sometimes referred to as the “Solow residual.” Initial estimates from the recent GDP release indicate that equipment and software investment in the third quarter moderated from the rapid pace recorded in the first half of the year. One data point does not make a trend, but an improvement in business investment will be important if the pickup in productivity growth that we have seen in recent quarters is to be sustained.

RIA Pro comment- The highlighted sentences in the paragraph above are important to understand. Productivity growth, demographics and levels of debt/money are the primary components of economic growth. Given, for the most part, that the amount of debt and demographic trends are a known commodity, productivity growth is the marginal determinant of growth. His statements above suggest that productivity growth has picked up recently but “one data point does not make a trend.” This means that a failure of continuing strength in capital investment by corporations will imply weaker productivity growth and therefore will signal weaker economic growth ahead.

As for the economic outlook, in the most recent Summary of Economic Projections (SEP) released in September, participants had a median projection for real GDP growth of 3.1 percent in 2018 and 2-1/2 percent in 2019. The unemployment rate was expected to decline to 3‑1/2 percent next year. And, for total PCE inflation, the median projection remains near 2 percent.

With a robust labor market and inflation at or close to our 2 percent inflation goal and based on the baseline economic outlook for 2019 I have just laid out, I believe monetary policy at this stage of the economic expansion should be aimed at sustaining growth and maximum employment at levels consistent with our inflation objective. At this stage of the interest rate cycle, I believe it will be especially important to monitor a wide range of data as we continually assess and calibrate whether the path for the policy rate is consistent with meeting our dual-mandate objectives on a sustained basis.

RIA Pro comment- As he implies above, the Fed is becoming more “data dependent.” Clarida has made that comment explicitly in prior speeches. In other words, their path towards more rate hikes or a suspension of hikes will be more heavily influenced by incoming economic data. This likely means that markets will become more volatile around major economic data releases. Furthermore, if the Fed does become more data dependent, that also suggests a reduced reliance on “forward guidance.” We will expand more on that later, but be aware that forward guidance is the Fed’s way of telegraphing to the markets where they expect rates to be in the future. In the past this guidance has proved comforting to the markets.

Data Dependence of Monetary Policy: What It Means and Why It Is Important
Economic research suggests that monetary policy should be “data dependent.” And, indeed, central banks around the world, including the Federal Reserve, often describe their policies in this way. I would now like to discuss how I think about two distinct roles that data dependence should play in the formulation and communication of monetary policy.

It is important to state up-front that data dependence is not, in and of itself, a monetary policy strategy. A monetary policy strategy must find a way to combine incoming data and a model of the economy with a healthy dose of judgment–and humility!–to formulate, and then communicate, a path for the policy rate most consistent with our policy objectives. In the case of the Fed, those objectives are assigned to us by the Congress, and they are to achieve maximum employment and price stability. Importantly, because households and firms must make long-term saving and investment decisions and because these decisions‑‑directly or indirectly‑‑depend on the expected future path for the policy rate, the central bank should find a way to communicate and explain how incoming data are or are not changing the expected path for the policy rate consistent with best meeting its objectives. Absent such communication, inefficient divergences between public expectations and central bank intentions for the policy rate path can emerge and persist in ways that are costly to the economy when reversed.

RIA Pro comment- Clarida alludes to something we wrote about in Everyone Hears the Fed, But Few Listen. Essentially, the comment highlighted above is in reference to the fact that the Fed is still projecting another 1% increase in the Fed Funds rate, while the market is currently estimating a smaller increase of .37%. Whether the Fed backs down from their forecast or they talk the market up to their level is important to follow. The reason it is important comes back to the topic of forward guidance. The difference in rate expectations (1% versus 0.37%) is evidence of less investor certainty about what the Fed may do. That uncertainty contributes to volatility by challenging the notion, as John Maynard Keynes put it, “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.”

Within this general framework, let me now consider two distinct ways in which I think that the path for the federal funds rate should be data dependent. U.S. monetary policy has for some time and will, I believe, continue to be data dependent in the sense that incoming data reveal at the time of each Federal Open Market Committee (FOMC) meeting where the economy is at the time of each meeting relative to the goals of monetary policy. This information on where the economy is relative to the goals of monetary policy is an important input into the policy decision. If, for example, incoming data in the months ahead were to reveal that inflation and inflation expectations are running higher than projected at present and in ways that are inconsistent with our 2 percent objective, then I would be receptive to increasing the policy rate by more than I currently expect will be necessary. Data dependence in this sense is easy to understand, as it is of the type implied by a large family of policy rules in which the parameters of the economy are known.

But what if key parameters that describe the long-run destination of the economy are unknown? This is indeed the relevant case that the FOMC and other monetary policymakers face in practice. The two most important unknown parameters needed to conduct‑‑and communicate‑‑monetary policy are the rate of unemployment consistent with maximum employment, u*, and the riskless real rate of interest consistent with price stability, r*. As a result, in the real world, monetary policy should, I believe, be data dependent in a second sense: that incoming data can reveal at each FOMC meeting signals that will enable it to update its estimates of r* and u* in order to obtain its best estimate of where the economy is heading. And, indeed, as indicated by the SEP, FOMC participants have, over the past nearly seven years, revised their estimates of both u* and r* substantially lower as unemployment fell and real interest rates remained well below prior estimates of neutral without the rise in inflation or inflation expectations those earlier estimates would have predicted. And these revisions to u* and r* almost certainly did have an important influence on the path for the policy rate that was actually realized in recent years. I would expect to revise my estimates of r* and u* as appropriate if incoming data on future inflation and unemployment diverge materially and persistently from my baseline projections today.

RIA Pro comment- Clarida resorts to economic jargon in the paragraph above to affirm his belief in the Phillips Curve. He is saying that lower levels of unemployment spur wage growth, and if that is occurring, interest rates should be higher to offset the effects of higher inflation caused by wage growth. This statement tells us that the monthly labor report from the Bureau of Labor Statistics (BLS) should be followed closely for signs of further strength in employment. Within the labor report, other important statistics include hours worked, wages and the participation rate.

Consequences for Monetary Policy

What does this mean for the conduct of monetary policy? As the economy has moved to a neighborhood consistent with the Fed’s dual-mandate objectives, risks have become more symmetric and less skewed to the downside than when the current rate cycle began three years ago. Raising rates too quickly could unnecessarily shorten the economic expansion, while moving too slowly could result in rising inflation and inflation expectations down the road that could be costly to reverse, as well as potentially pose financial stability risks.

Although the real federal funds rate today is just below the range of longer-run estimates presented in the September SEP, it is much closer to the vicinity of r* than it was when the FOMC started to remove accommodation in December 2015. How close is a matter of judgment, and there is a range of views on the FOMC. As I have already stressed, r* and u* are uncertain, and I believe we should continue to update our estimates of them as new data arrive. This process of learning about r* and u* as new data arrive supports the case for gradual policy normalization, as it will allow the Fed to accumulate more information from the data about the ultimate destination for the policy rate and the unemployment rate at a time when inflation is close to our 2 percent objective.

RIA Pro comment- In the final two paragraphs, Clarida is essentially relaying that the Fed Funds rate is much closer to its terminal value than when they started raising rates in 2015. While obvious, the statement seems to convey a feeling that future rate hikes will require more robust data than that seen over the last three years.

RIA Pro Summary:

In general, we are not swayed that Clarida is looking to stop Fed Funds rate hikes, but he makes it apparent that weakening economic growth and any slowdown in employment data will result in a more dovish Fed. As is now customary for Federal Reserve officials, Clarida is making a bold attempt to “have his cake and eat it too.” Broadcasting the Fed’s tendencies with regard to interest rates through forward guidance has afforded the Fed tremendous power over guiding market expectations and thereby reducing volatility. Their wish is to maintain that influence, but doing so while raising interest rates is a very different circumstance than doing so while lowering them.

As was the case when the Fed expressed 100% certainty about implementing extraordinary policies, they are now desperately trying the same approach but while keeping a foot in the exit door. More than anything else, what they want to avoid is being caught dead wrong as they were about the housing market and economy in 2007-2008.

Simply said, on the one hand, Clarida wants to convey certitude about the economic outlook and the Fed’s path, on the other hand, he is trying to reserve the right to be wrong. We would applaud an honest acknowledgment of possible alternative outcomes, but his approach in this speech was more than a little ham-handed.

In July of 2015 and again in late November of 2016, bond yields were surging higher which prompted us to recommend that our readers consider investing in Closed-End Funds (CEF) that hold municipal bonds (Muni CEF). In the wake of rising yields, there were some dislocations which we believed presented a great opportunity for investors who felt that increase in yields was temporary. In both instances, yields halted their increases shortly after our recommendation, and as we suspected, readers that followed our advice were rewarded with double-digit returns in a relatively short time frame.

Since mid-2016, the yield on the 10-year U.S. Treasury Note has risen nearly 2% and stands at levels last seen in 2011. For those who believe the recent rise in interest rates is at or near a peak, we believe Muni CEFs once again offer similar opportunities. The following article shares highlights from our prior articles that help explain what Muni CEFs are and what drives their return. The article concludes with a fresh analysis of six funds that we believe can produce favorable returns going forward.

Before preceding, we want to stress that this recommendation is for those that think yields are at or near their short-term peak. If yields continue to rise it is quite possible that Muni CEFs, due to their leverage, could underperform individual municipal bonds and other fixed income sectors.

What are CEF’s?

Closed-End Funds (CEF’s) are mutual funds with a fixed number of shares, unlike most other mutual funds whose share count fluctuates daily with investor interest. Also differentiating CEF’s from open-ended mutual funds is the fact that CEF shares are bought or sold on exchanges, not via direct transactions with the associated mutual fund company. It is this unique feature that results in CEF’s trading at a premium or discount to their net asset value (NAV).

The three biggest factors which determine why a CEF might trade at a premium or discount to its NAV are:

1. Strong demand and/or low supply of the fund may result in a premium, while weak demand and/or excess supply will frequently result in a discount
2. Quality of the fund management team
3. The liquidity of the underlying fund holdings

The change in the premium or discount to NAV is just one factor determining total return for CEFs. The table below highlights all of the factors influencing the total return for M-CEF’s.

The following table from our 2015 article highlights key statistics from the date we recommended the funds to the date we recommended taking profits. Reviewing the sources of returns allows us to better understand how gains may be achieved this time around.

Sources of 2015 gains:

• Coupon yield- The funds we recommended had an average yield of 6.41% which provided reliable income.
• Price appreciation due to yield- After a six month period, the yield on the funds declined to 5.98%. As a result, the prices of the underlying bonds and therefore the net asset value of the CEF’s rose by approximately 2.50%. Because the funds are leveraged the price appreciation was closer to 3.50%.
• Price appreciation due to discount to NAV- In July of 2015 the average discount was at or near the respective lows since 2013. Over the next six months the average discount to NAV would rise from -11.19 to -8.03, resulting in an additional 16% of price gains on the CEF’s.

Current Recommendation

Yields are currently on a trajectory higher for a number of reasons. First and foremost is a widely held concern amongst bond investors that strong economic growth and low unemployment will push wages higher and spur more inflation. Second, the U.S. Treasury will offer over $1 trillion of debt this year and is forecast to do the same over the next few years. The heavy supply is creating an imbalance that has pushed yields higher. As an aside, we will have more to say about who is buying U.S. Treasury debt and why it matters in an upcoming article.

The following paragraph was from 2016, the second time we recommended Muni CEFs. We believe it is just as pertinent today:

“Having begun in 1981, the current bull market in bonds is well-seasoned and no doubt much closer to the end than the beginning.  At the same time, the velocity of money is still declining in the U.S., the U.S. dollar is strengthening versus other currencies and global deflationary forces emanating from abroad remain influential.  The U.S. economy is more sensitive than ever to the level of interest rates and economic stress resulting from higher yields could easily halt economic growth and push the economy into recession. In such an instance, the Fed would likely end the normalization of rates and take actions to bring the Federal Funds rate back to zero or even lower.  Additionally, the Fed could re-introduce QE. If some form of these events unfold, Japan remains the most reliable model for the path of interest rates in the U.S.”

Higher interest rates are already depressing economic activity in interest rate sensitive sectors such as housing and autos. There is little doubt in our mind that as the benefits of fiscal stimulus erode over the coming quarters and the Fed continues to raise rates and reduce their balance sheet (QT), the economy will slow and inflationary impulses will subside. Such a result would help put a lid on rising interest rates. While timing is difficult and yields can certainly rise further, we believe that yields will peak, either now or within the next few months, and Muni CEF’s will offer similar opportunities as in the past.

We selected the following six Muni CEFs based on a number of qualifications, including but not limited to leverage, credit, expense ratio, and discount to NAV.

Summary

Given the move in interest rates in 2018, reluctance to take on investments that are negatively affected by higher rates is understandable. However, due to the nature of our highly leveraged economy, past episodes of rising interest rates have been met with faltering economic growth, deflationary impulses and ultimately lower interest rates.

Muni CEFs offer a counter-trend position to take advantage if interest rates reverse course. Further they offer a margin of safety in the form of steep discounts to their NAV.

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.