Patience Is a Virtue (Especially in Municipal Bond Investing)

 

March 17, 2017 [Rising Rates, Municipal Bonds, Interest Rate Environment]
Christopher Ryon, CFA


It is St. Patrick’s Day and I am thinking of my grandmother, who used to make the most horrific corned beef and cabbage every Wednesday night; the corned beef had a metallic sheen. So when I am offered corned beef and cabbage on this day I always shudder and decline. But she also quoted a saying that has been ringing in the back of my mind as I contemplate a rising interest rate environment: Patience is a virtue, Possess it if you can, Seldom found in woman, Never found in man.

In a rising interest rate environment patience is an extremely important character trait for investors. They need to examine their investment horizons, make sure they are appropriate for their circumstances, and be prepared to patiently ride out periods of volatility. To test this strategy I looked at the annualized total returns of several Bank of America/Merrill Lynch municipal bond indexes representing four segments of the municipal bond market (short, limited, intermediate and broad) over six periods of rising interest rates dating back to 1994. I examined two annualized return periods over the last roughly 23 years: the initial period of rising interest rates and the period including an additional 12 months—the patience period, if you will. The graph illustrates the periods chosen:

Yield of a 10 Year AAA General Obligation Bond 6/30/1994–3/17/2017

Source: Bloomberg

The first six circled time periods represent rising interest rate environments; the last circled period is the current monetary tightening phase, and we do not know what is going to happen 12 months from now. Anyone who claims to know may be a wee bit delusional and might as well seek the leprechaun’s hidden pot of gold.

The next portion of the exercise is to look at the annualized total returns for the two aforementioned periods; the next two tables show these results:

Annualized Total Returns for the Initial Period Of Rising Interest Rates

Period of Rising Interest Rates 1-3 Year Market Segment 1-12 Year Market Segment 12-22 Year Market Segment Broad Market
1/31/1994–12/31/1994 0.749% -3.818% -6.609% -7.735%
2/16/1996–6/30/1996 1.826% -3.136% -2.458% -4.099%
1/31/1999–12/31/1999 1.974% -1.500% -6.611% -8.177%
6/30/2008–11/30/2008 5.083% 3.923% -14.305% -11.902%
9/30/2010–1/30/2011 -0.549% -6.574% -17.802% -15.790%
1/1/2013–12/31/2013 1.071% -0.116% -6.080% -2.891%
Source: Bloomberg
Market Segments are represented by the BofA Merrill Lynch 1-3 year, 1-12 year, and 12-22 year Municipal indices. The BofA Merrill Lynch Municipal Master index was used to represent the Broad Market.

I choose to use annualized total returns for both the initial period of rising rates and the patience period for two reasons. First, behavioral finance tells us that people have a tendency to project the last thing to happen into the future, so annualizing the initial period of rising rates captures this behavior. Second, the annualized returns for the patience period standardizes the analysis.

The conclusions drawn from the table above are quite simple. In most periods of rising rates the shorter maturity segments of the municipal bond market tend to outperform the longer maturity segments. Therefore investors fearing the continuation of rising interest rates should move to shorter duration segments of the municipal bond market. But the real question then arises, “Is that the correct decision?” The next table will shed some light on the answer.

Annualized Total Returns for the Initial Period Of Rising Interest Rates Including the Patience Period

Period of Rising Interest
Rates Including the Patience Period
1-3 Year Market Segment 1-12 Year Market Segment 12-22 Year Market Segment Broad Market
1/31/1994–12/31/1995 4.078% 4.812% 5.434% 4.763%
2/16/1996–6/30/1997 3.721% 4.189% 5.473% 4.978%
1/31/1999–12/31/2000 3.892% 4.167% 4.847% 4.278%
6/30/2008–11/30/2009 5.002% 7.607% 6.920% 6.505%
9/30/2010–1/30/2012 1.675% 4.846% 6.810% 6.476%
1/1/2013–12/31/2014 0.896% 2.055% 2.664% 3.253%
Source: Bloomberg
Market Segments are represented by the BofA Merrill Lynch 1-3 year, 1-12 year, and 12-22 year Municipal indices. The BofA Merrill Lynch Municipal Master index was used to represent the Broad Market.

The results provide a clear, compelling answer:

1. When interest rates rise, short duration securities outperformed longer duration securities, at least initially.

2. In the six periods examined, if investors were patient, longer duration securities (in most cases) outperformed shorter duration securities over the longer period examined.

3. Past is not always prologue, but panic is never a good investment philosophy

4. My grandmother may not have been able to cook corned beef and cabbage, but she was a really wise woman!

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