Spring forecast for muni buyers
March 11, 2016
After a long period of uncertainty in 2015 about whether the U.S. Federal Reserve would at last raise interest rates after eight years, along with a certain amount of market seesawing during the latter half of the year, market participants entered 2016 hopeful. This optimism was only to be met with deep turmoil and volatility in the winter months that threatened to leave investors out in the cold. With the approach of spring, however, it has become clearer that, in addition to the traditional refuge of U.S. Treasurys, municipal bonds may be considered a safe haven and buying opportunity.
The seeds of uncertainty and volatility were sown by the end of 2015. Investors entered the new year expecting interest rates to rise. After all, the Fed’s Open Market Committee (FOMC) raised the federal funds target rate in December 2015 for the first time in nearly a decade, increasing it by 25 basis points, from 0.25% to 0.50%. Following that rate hike, fed funds futures probabilities were pricing in by Dec. 31 a more than even chance (50.8%) of another rate hike at the FOMC’s March 2016 meeting, with an additional rate hike before the end of the year (source: Bloomberg).
As 2016 began, however, risk markets went into free fall — due to uncertainty about China’s intentions for its currency, a continued decline in commodities, particularly oil, the recent move to negative interest rates in Japan, and as the United States, long seen as the standard to emulate, experienced mixed economic data with the exception of some consistent growth in payrolls.
As a result, we began to see risk-off trade occur. By mid-February, the S&P 500® Index was down more than 10%, corporate bond spreads widened, and both developed and emerging market stocks were off their previous highs considerably. In less than two months, the fed funds future contracts were trading at a 0% probability of a March rate hike and only a 29.6% chance that the Fed would raise rates in December. In reaction, not only U.S. Treasurys but also municipal bonds rallied, their prices increasing and yields declining. By Feb. 11, the 10-year U.S. Treasury yield had dropped 36 basis points to 1.66% and the 10-year AAA municipal bond yield had declined 30 basis points to 1.56%.
Going into March, market expectations changed again. Risk markets rallied, while interest rates rebounded higher. The risk trade was bolstered by improving commodity prices and better U.S. economic data, highlighted by employment growth. Nonfarm payrolls grew 242,000 in February and have averaged gains of 235,000 over the last six months. These improvements have still resulted in fed funds futures trading still pricing in an extremely low probability of a March rate hike, only 8% — and only one rate hike for all of 2016.
Because expectations shift and market sentiment changes over time — and volatility can occur day to day — patterns are notoriously unpredictable. Municipal bonds, however, have shown a more reliable pattern, not only for historical performance, but also because of the seasonal supply and demand found in municipals.
The chart below shows a pattern of municipal bond monthly returns as measured by the Barclays Municipal Bond Index over the past 15 years. In addition, the graph demonstrates technical strength seen in January, driven by low supply and high demand of municipals. The January 2016 new-issue municipal bond supply declined 18% from 2015’s supply, while mutual funds saw inflows of more than $5 billion. This depiction also demonstrates technical weakness in March, as supply usually builds and investors are preoccupied with tax season.
In 2016, the calendar of new issues has picked up while tax-exempt bond fund flows have remained positive, although they have recently moderated. It appears the new money flows remain on the sidelines. So municipal bond yields have risen since mid-February 2016 with the 10-year AAA municipal bond yield now back at 1.90%. As the chart demonstrates, these dips on average generally represent a good buying opportunity for some investors, as the market tends to rebound in April.
Munis’ cyclical nature can mean opportunities
Barclays Municipal Bond Index, average monthly returns, 2001–2015
Chart is for illustrative purposes only.
This tendency, over a 15-year period, represents an average, and is not a guarantee. Still, we feel investors should be looking at the long-term income generating portion of their asset allocation and use these dips to take advantage of cheaper prices and higher yields. After all, we believe income is the most important component of total return over the long term.
The views expressed represent the Manager's assessment of the market environment as of March 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
Bond funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to state or local taxes and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.
Bonds are rated by nationally recognized statistical rating agencies that include Standard & Poor’s, Moody’s Investors Service, and Fitch, Inc. Bonds rated AAA represent highest quality; however, the security’s credit rating does not eliminate risk.
The Bloomberg Barclays Municipal Bond Index measures the total return performance of the long-term, investment grade tax-exempt bond market.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.