Muni bonds suffered a rout recently when anxiety over the Fed’s taper of bond buying roiled fixed-income markets, leaving many investors wondering where to turn. As it turns out, munis have historically been effective shock absorbers. We believe that, given the right positioning, munis can help weather rising rates.

Most investors are aware of the tax advantages of munis. Coupon income is generally exempt from federal taxes and, if investors live in the issuer’s state, often from state and local taxes too. But munis have something else going for them that may come in very handy when Treasury yields rise: they typically don’t act like Treasuries.

Marching to Their Own Beat

When Treasury yields rise, bond yields in most other market segments rise too—but not to the same extent. This behavior generally holds true for munis, too. Over the long term, municipal bond yields have been much less volatile than Treasury yields. And because muni bond yields typically rise by a good deal less than Treasury yields, the result is less downward pressure on prices.

Why Are Munis Less Volatile?

So, the data show that municipals generally move about half as much as Treasuries when interest rates start to rise. But why? We believe it’s because investors compare municipal yields to the after-tax yields of Treasuries. For example, if pre-tax Treasury yields are 2.5% today and rise to 3.5% in the future, the after-tax Treasury yield changes from 1.4% to 2% for an investor in the top federal tax bracket—only 50% to 60% as much as the pre-tax Treasury yield.

Of course, we don’t expect munis to act exactly the same every time rates rise. In fact, recent taper concerns unnerved many muni investors, who pulled money from muni funds at an unprecedented pace. Prices fell sharply and muni yields rose more than they usually would. In fact, they rose more than Treasury yields at many maturities in the second quarter.

Based on our research, this behavior is uncommon. Over one-month periods since 1985, muni yields rose more than Treasury yields only a quarter of the time. And over one-year periods, which would be consistent with a more gradual rate rise, muni yields rose more than Treasury yields only 13% of the time. This is important, because in our view rates are likely to rise gradually.

Positioning for Rising Rates

Other return elements have time to contribute when rates rise gradually. There’s coupon income, which is attractive on an after-tax basis—and which can be reinvested in progressively higher-yielding bonds. Yield-curve “roll” also comes into play. Roll is the natural price gain a bond experiences as it moves closer to maturity. As a bond’s yield declines with the passage of time, its price rises due to the inverse relationship between yield and price. Our forecast is for rising rates, but income and roll can potentially help counteract some of the price impact over time, acting as a shock absorber.

Certainly, not all muni bonds will fare well when rates rise. Long-term bonds have already declined significantly, and some investors may now be tempted by their higher yields. We continue to suggest underweighting these long-maturity bonds; their values are very sensitive to changes in interest rates, and investors can get similar expected returns with intermediate-term bonds when income and roll are considered. In addition, buying long-maturity bonds at a significant discount to par value can in some cases create a hefty tax bill for the investor, as the discount, if large enough, is subject to ordinary income tax.

To make up some of the yield investors would give up by moving to intermediate-term munis, exposure to lower-rated bonds can help—their yield advantage is above average today. Also, lower-rated bonds tend to be even less rate sensitive, because issuers’ credit quality tends to improve when rates rise in a strengthening economy. This trait can provide lower-rated bonds with an extra counter to the price losses from higher rates.

Lower-rated bonds did underperform in the recent sell-off, but not because of weaker credit quality. According to the Nelson A. Rockefeller Institute of Government, tax collections increased for the 13th straight quarter in the second quarter. Of course, it takes solid research and security selection to identify the stronger municipalities—one look atDetroit’s bankruptcy is a reminder. Bear in mind, though, that muni defaults are still extremely rare.

Hand-wringing and doom-and-gloom predictions aside, we think munis are well equipped to weather a rising-rate environment—provided that investors do some weatherproofing as needed.

The views expressed herein do not constitute research, tax advice, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.

Clients Only

The content you have selected is for clients only. If you are a client, please continue to log in. You will then be able to open and read this content.