As COVID-19 vaccines roll out and resrictions lift, a US economic rebound could lead to tighter Federal Reserve policy and higher yields. Municipal bond investors may worry about how rising yields could hurt their portfolios.
Muni credit could be one solution. Historically, when Fed rate hikes spurred higher yields, BBB-rated municipals beat US Treasuries and AAA-rated munis (Display left).
That’s because municipal bonds rated A, BBB or below investment-grade enjoy not only extra yield, which serves as a buffer against loss, but also the potential for a relative price boost as their spreads narrow versus AAA munis. We think that’s likely to happen as the economy regains its footing. The result? Higher expected returns, particularly for longer maturities (Display right).
In our estimation, a five-year, AA-rated muni would see 0% returns if yields were to rise just 15 basis points, while yields would have to rise nearly 50 basis points for the return on a 20-year, BBB-rated muni to drop to zero. When economies improve, yields tend to rise. And when yields go on offense, muni credit has offered muni investors a powerful defense.